Torii® Asset Management

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The Worst Best Times

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I hope life is moving towards some resemblance of normalcy. Despite the craziness of the past few months, I believe it may worsen as the election approaches and each party vies for votes by any means. Hopefully much of the current skewed information will dissipate after the election contests pass.

My last quarterly review in April seemed like the worst of times with the US unemployment rate hitting a near-term record of 14.7 percent, and the S&P 500 stock index being down 20% amidst the unknowns of the COVID-19 pandemic.  Yet now seems like the best of times, at least if you are looking at the NASDAQ stock index, which has recently set a new high.

During the second quarter of 2020, the S&P 500 Index gained 20.0%, the NASDAQ Index gained 30.6%, the Russell 2000 Growth Index gained 30.4%, and the iShares Barclays 7-10 yr. Treasury Bond ETF (IEF) gained 0.3%. (1)

This quarter’s stock market performance was remarkable and was prompted by the Federal Reserve’s quick measures of providing liquidity to financial markets and lowering the federal funds rate back to its historic low range of 0% to 0.25% and the government’s $2.2 trillion coronavirus rescue package. 

Currently, investors wonder where we are now and what will happen in the future. To provide perspective, as of the 2019 year end (YEND) the unemployment rate was 3.5% but by April it jumped to 14.7% while the gross domestic product (GDP) growth rate went from a +2.1% at the beginning of 2020 to -5.0% annualized rate at the end of the first quarter. In June, the unemployment rate improved to 11.1% and the second quarter GDP estimate is yet to be released.

 (1) These returns are priced based and exclusive of dividend reinvestment.

The June 10, 2020 Federal Open Market Committee (FOMC) projections are listed in the below table.

Chart of FOMC projections

There are a few key takeaways gleaned from these numbers. The first is that unemployment rates remain at levels which puts pressure on consumer spending.  Consumer spending makes up more than 70 percent of the economy, and it usually drives growth during economic recoveries. This idea puts into jeopardy the 5.0% growth estimate for 2021 which would still not bring us back to the 2019 level.

In my estimation, the back stopping of the Federal Reserve and Government have been catalysts in running the stock markets to price levels which may not justify future earnings. I continue to expect a near-term correction, not crash, to emerge as the COVID-19 health and economic scenario plays out and the noise from the election snowballs into the fall.

Another question I am asked concerns the shape of the recovery. Jamie Dimon the chairman and CEO of JPMorgan Chase, the largest of the big four American banks, when asked about the future commented on Bloomberg “We simply don’t know. I don’t think anyone knows.” Evidence from the Fed also confirms the ambiguity of the future. Following their sensitivity analyses, results indicate that US banks can remain strong in the face of even the harshest shocks;  they proceeded to run a series of hypotheticals to test how banks would fare in the face of “a V-shaped recession and recovery; a slower, U-shaped recession and recovery; and a W-shaped, double-dip recession. They found that most banks would remain well capitalized under the differing scenarios, but several would approach minimum capital levels.

Short-term investors are the ones who should concentrate on the shape of the recovery since their livelihood depends on accurately capitalizing on trading the market swings; while longer term investors should concentrate on the variables surrounding earnings growth, and that liquidity remains in the financial system. In the last downturn, it was greatly exacerbated by the forced selling of securities into a suddenly illiquid market by leveraged (borrowed) investors and financial institutions which were required to maintain minimum capital requirements.

For investors today, there are positives and negatives to note:

Positives:

  1. The financial and economic markets continue to function.
  2. Low inflation expectations, as described by the FOMC PCE inflation in the table above.
  3. High money market levels which could be a catalyst to future stock buying or a backstop during a correction. Note that money-market funds as % of Russell 3000 market cap is near an extreme.
  4. The Fed seems to be all-in in providing financial backing to corporate America by extending their bond purchases to include corporate debt. This is both good and bad as it enables companies to build cash 
Assets in money-market funds as % of Russell 3000 market cap – graph

Negatives:

  1. Under a cautious tone, JPMorgan Chase (JPM) earnings commentary on July 14th included guidance that they are bracing for double-digit unemployment through the first half of next year on expectations of “much more protracted” pain, as rising U.S. coronavirus cases re-close the economy. This is the company whose well respected CEO said “We simply don’t know. I don’t think anyone knows.”
  2. Real Estate, Airline, Entertainment, Leisure industries continue to struggle.
  3. The implications of the CARES Act loan forbearance conclusion are unknown. The CARES Act is not specific when it comes to what happens once the forbearance period ends. As a result, individual lenders and servicers are setting different rules about how borrowers must make up the delayed payments.
  4. It is an election year.

Here at Torii Asset Management, we do not just buy or sell the market on headlines or guesses, but rigorously delve into the mechanisms which the economy and companies operate.

We concentrate on:

  1. Valuation, earnings, and earnings to growth rates in context to their competitors, the overall market, and other investments.
  2. Risk of the company being able to meet theirs, ours, and others’ projections, but more importantly our client’s individual risk profiles.
  3. Economic environment – is the path for continued company growth in alignment with the economic trend.

The path forward is a scary one since there are many unknowns, but here is how I am handling it. With the dramatic bounce from the March lows, it is a prudent time to maintain a cash position to mitigate risk. The amount of cash depends on each client’s profile. This is a period where it is essential to be working with an independent advisor who can take measures to serve your interests. Otherwise you may be stuck in an investment plan that is mandated to be fully invested which means full risk all the time.

For the balance or investable funds which can be used for growth, the upcoming earnings season should be very insightful in identifying which companies have prospered and can provide guidance for continued growth. These companies will be purchased, but only if their price provides material upside to their projected earnings and growth rate. I believe a couple areas of continued interest will be in the electronic commerce, 5G build out, and cloud services areas. There may also be some surprises in the industrial complex as supply line flow returns and products are delivered.

The worst and best of times of the past few months has been an eye-opener for many, and it is an appropriate time for all investors to look deep inside and make a frank assessment of their current and future needs, expectations, and tolerances. If I may be of help, please let me know.

To our existing clients, I extend my sincere thanks for your business. You have our continued commitment to your success. To prospective clients, I invite you to come and grow with us.

Very truly yours,

Martin L. Yokosawa