There is a major disconnect between the stock market and the underlying economy. 16.9% of the civilian labor force continues to claim unemployment benefits. Not seasonally adjusted, initial jobless claims for state and federal picked up to 1.43 million during the week ending August 22nd, 2020 while continuing jobless claims were at 27.02 million. The GDP numbers are down as well because the economy was brought to a stop and has not come back to pre-COVID 19 levels. Yet, the stock market is roaring. How is this possible?
The stock market is a forward looking mechanism, based on people’s beliefs of what they think the economy will look like 6-12 months into the future. Those beliefs are attracting a lot of money into the stock market right now. A plethora of money has been created by the Federal Reserve with the result of increasing the money supply, and therefore the levels of available liquidity. The majority of this extra liquidity is finding its way into the asset market.
People from around the globe are also being attracted to the US stock market as a result of the robust yields being paid. Investors, both in the US and around the globe, have been forced into riskier markets primarily due to a low interest rate environment with many sovereign bonds now in negative yield territory. These are contributing factors for why the stock market is going up despite weakness in the underlying economy. Another important factor in the rising stock market as well as strength in precious metals is the weakening US Dollar. You can also see this influx in the stock market reflected in the price of gold, which is trading at $1938/ounce.
US Dollar Value
On March 19th of 2020, the DXY was at 102.94. On September 1st 2020, the DXY is less than 93. The DXY is an index (or measure) of the value of the US dollar relative to a basket of foreign currencies. Specifically, it is a weighted geometric mean of the dollar’s value relative to a composition of currencies made up of the Euro, Japanese yen, British Pound sterling, Canadian dollar, Swedish Krona and Swiss franc. The higher the DXY number, the stronger the US dollar.
The tremendous move down from the March high until now means that the purchasing power is down 10.2%. This results in the dollar being able to purchase less goods and services. It also results in the stock market inflating to compensate for a weaker dollar as well as higher prices in precious metals like gold since they are priced in US dollars. So, if you’re looking to gain dividends, should you invest in the stock market? A portion probably, but not 100% of your respective investable funds. Why?
There is uncertainty out there. The stock market is driven by sentiment, by waves of pessimism and optimism. If you are optimistic, you may even buy stock on margin (borrowing money to purchase stock). If you are pessimistic, you could dump all of your stocks. People right now are very optimistic relative to US companies and the stock market. We see this when we look at companies like Amazon, Apple or Tesla. Tesla’s price to earnings ratio is over 1000. That means that people are willing to pay $1000 today for one dollar worth of earnings in the future. Why are people making that type of investment decision during an economic crisis?
The only exposure many people have to the stock market is through their 401k plans. As the stock market has continued in its ascent higher, these 401k plans have continued to grow, therefore giving people a feeling of wealth. With the Federal Reserve becoming the buyer and lender of last resort, it has distorted markets in a way never seen before. The Federal Reserve has purchased Exchange Traded Funds as well as the debt of many companies underwater due to their tremendous debt loads.
Some of these companies took money that they had borrowed and re-purchased their stock in stock buyback programs. Stock buybacks have the effect of artificially inflating earnings per share due to removing the number of shares outstanding on the open market. Since 2008, a significant number of companies have grown earnings per share through this type of financial engineering rather than through increased productivity. So, what is the role of traditional safe haven investments like precious metals?
Precious metals such as gold are looked upon as a safe haven. A safe haven investment is an investment that is expected to retain or increase in value during times of market turbulence and uncertainty. Safe havens are sought by investors to limit their exposure to losses in the event of market downturns or black swan events. A black swan event is a metaphor that describes an event that comes as a surprise, has a major effect and is often inappropriately rationalized after the fact with the benefit of hindsight.
During periods of market turbulence, precious metals such as gold as well as US Treasuries are purchased as safe haven investments. The 10 year bond yield on US treasuries today is 0.742% while in 2019 the average yield was 2.14%. The price of gold in 2020 has reached a high of $2070 USD per ounce while in 2019 the high was $1550. This is because Us Treasuries and gold are safe havens that people go to and purchase during times of crisis such as COVID-19. Fiat money, or currency established as money, is backed by nothing except the full faith and credit of the issuing country. Take for example, Zimbabwe, Germany, or Argentina. All of these countries have histories of their government’s flooding the market with money printed out of thin air, resulting in currency that soon had no value.
The Federal Reserve’s current federal funds rate is at 0-0.25%. As stated previously, lower interest rates encourage investors to seek out higher yields, taking on more risk and the only place offering that currently is the stock market. However, with a US presidential election taking place in November, 2020 along with the continued negative effects on the economy due to the pandemic, if people start becoming pessimistic a significant downdraft in the stock market may occur. When things crash, everyone runs for the exit door at the same time. They don’t sell what they want to sell, they sell what they can sell.
The Bottom Line
There has been a major transfer of wealth due to government intervention and the US government will continue to print money. The Federal Reserve has become the buyer and lender of last resort. America’s elected leaders have the challenging task of creating a system that will ensure that all Americans have the opportunity to achieve their highest aspirations and goals while being able to put food on the table for their family.
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