Quarterly Letter

October 2020 – Quarterly Letter

By October 29, 2020 No Comments

October 28th, 2020

Waiting for the World to Change


During the third quarter, the economy continued to awaken from the spring shutdown. Traffic surveys suggest that in-person economic activity is back up to at least 80% of where it was before the shutdown. It also appears that significant economic activity is occurring from home. Companies that benefit from workers spending more time at home are leading the market’s recovery.

We are not out of the woods yet. Public health experts are concerned about a resurgence of the Covid pandemic in the fall and winter.  Concerns about the next wave and about the congressional economic relief bill drove market volatility over the last month. The market is currently about ten percent below the high from September 2nd.   Wall Street was confident that Republicans and Democrats would reach an agreement for the next stimulus package, which would have sent another round of checks to individuals and businesses. Wall Street apparently does not have a clue when it comes to D.C.

­­­­­­­­The concern is that without this stimulus, the economy is at risk of falling back into recession. It is hard to say how much the economy would falter in the absence of an agreement. The range of the stimulus package that they are negotiating is between two and three trillion dollars. At the low end, this would be about three times the size of the Obama stimulus plan coming out of the 2009 recession. Investors will likely get their wish eventually, but it might not come until after the dust settles from the election. If the President loses, Mitch McConnell will slow play any agreement, probably delaying until the new senators take their seats.

The election is driving everything right now. The market tends to stagnate leading up to the election as investors process the wide range of possible outcomes. The lack of visibility on the structure of the government over the next few years creates massive uncertainty. In the market, uncertainty equals risk, and asset prices are discounted to reflect this risk. This uncertainty is only temporary, however, as we inevitably get through the election. This year may take a bit longer than usual. Many are predicting that the market will tumble if a close election goes to the courts for a resolution. In the very unlikely event that the election is too close to call, investors will move away from stocks to hide out from the uncertainty. This would also be a temporary challenge. The Constitution requires that we inaugurate a president on January 20th.

If Democrats sweep next week, investors will assume that spending will increase faster than taxes. This will give a boost to the economy. A Biden win plus a Republican senate might be the market’s preference as the stock market seems to do best when there is gridlock in Washington. The economics textbooks say a bigger deficit leads to a weaker dollar. The dollar has depreciated somewhat since April of this year as the likelihood of a Biden has increased.

The market will be fine regardless of which party has the better night on November 3rd. Some industries will benefit from a Biden presidency while other industries prefer a Trump administration. Overall, who controls Washington seems to have little relevance when it comes to predicting future market performance.

Amidst all the uncertainty of 2020, the market is crowding into the companies in which they have the most confidence. Investors are content to hold high valuation companies that have the highest certainty of growing their sales. Tech companies and companies that benefit from people increasingly working from home are capturing most of the gains in the current market environment. Some clients are probably wondering why we bother to diversify into small stocks or international stocks when a concentrated technology portfolio would have worked the best over the last ten years.

We are overweight technology, with about 35% of our portfolio in the sector, compared to the S&P 500 which has about 30% in technology. Unlike in the late nineties, the market is differentiating between the losers like IBM and Intel, and the winners like Adobe and Nvidia. The key to successfully owning these companies is to continue to hold them as they execute their business model, regardless of valuation. At the point that a competitor renders the company obsolete you must move on. There is little benefit to owning Blackberry as the iPhone captures market share.

The valuations of the tech industry are greater today relative to the overall economy than they were at the peak of the dot-com bubble in 1999. Technology investors argue that future earnings growth justifies the present valuation. They may have a point. In 1999, tech stocks traded at an inconceivable twenty-five times sales! Today, tech stocks trade at seven times sales. Seven times sales is an aggressive valuation, but if the sector continues to grow as quickly as it has over the last decade, investors will likely come out ahead.

There are challenges that we must overcome, but we will, at which point the market will probably experience a substantial internal change. Companies that rely on a strong economy to grow earnings have sat out the recovery so far. The combination of a political regime change and an eventual mitigation of the pandemic will likely push us into a new chapter of market behavior.

Eric Barden, CFA