Of Sand and Sea

Published On: April 2, 2020

Written by: Ben Atwater and Matt Malick

Markets are impossible to predict because they look ahead.  The collective wisdom of millions of investors has an uncanny ability to foresee problems and opportunities long before they arrive.  Markets were ahead of the COVID-19 healthcare capacity emergency and the present economic downturn.

Ultimately markets will look past the sand and out to the sea.  Despite robust rallies over the last week, stocks are likely not out of the woods yet, but the market tide will turn before we have clarity on the economy or even the health emergency.

Although the market will eventually look past the virus to brighter days, the government’s ability to stimulate through this downturn, although very powerful, will likely have a more limited impact. 

The Federal Reserve’s balance sheet went from less than $1 trillion before the 2008-2009 financial crisis to over $4.5 trillion as we came out on the other side. 

Due to coronavirus, the balance sheet promises to explode even higher.  There is a law of diminishing returns when it comes to the Fed’s efforts to save markets and stimulate the economy.  What once took $1 trillion pre-financial crisis to keep the system functioning well, took $4 trillion post-financial crisis, and now promises to require several trillion more. 

The same goes with debt.  Just two months ago, the federal budget deficit was expected to be $1 trillion in 2020.  It could now be well above an annualized $3 trillion due to COVID-19 stimulus.  However, each additional dollar of debt is less effective in stimulating the economy.  Nonetheless, the government is sure to employ a “whatever it takes” approach.  The question remains though, can they act quickly and efficiently enough? 

The narrative right now is that the economy was incredibly strong coming into coronavirus.  It was, but artificially so.  The government buoyed the economy with a $1 trillion fiscal deficit and with a $4 trillion Fed balance sheet. 

Compare this to the end of our last great boom – the 80s and 90s – which ended in 2000.  At that time, we had a $230 billion budget surplus and the Fed balance sheet was under $1 trillion.  We confront the current crisis in a precarious position as we have been robbing Peter to pay Paul and we now will accelerate the larceny. 

Additionally, we came into this crisis with extremely high market valuations.  Total stock market capitalization to GDP before the recent decline was almost 160%, well above the 140% level at the height of the dot com bubble.

This is not to say that equity investors can’t do well over the next five years.  But it seems unlikely that government stimulus will drive stocks consistently higher as it did in recent years.  Rather, we argue patience will be the primary ingredient of future success.  A continued choppy, volatile environment will require extreme patience and more active management.  A strong investment discipline will matter more than ever.  We believe we have the investment framework to thrive.