The Armageddonists

Market drawdowns and Bear Markets are a reality when it comes to investing in the equity markets. Part of the reason equity holders receive a higher long-term return over ‘safer’ investments such as bonds is that they take on additional risk and the likelihood that their investment will be negative over stretches of time. Of course no investor wants to experience their investment losing money but this year illustrates perfectly why sticking to a plan and staying invested while owning proven enterprises with strong balance sheets is the prudent approach. This fact of investing is nothing new but the rise of social media and the competitiveness for media headlines since 2010 have given way to a flood of negative market calls which naturally appeals to human negativity bias and our survivorship instincts. This appeal strategy has worked in part because the flood of calls followed two of the deepest bear markets since the great depression: The Tech Bubble & Global Financial Crisis.

Of course, just as there is inherent risk with being invested in the equity markets, there is also risk in not being invested.This is through the opportunity cost of trying to time the markets by jumping in and out of investments or dramatically drifting away from asset allocations due to “Armageddonist” media headlines. For example, $1 shifted from equities to bonds in 2014 in response to mega-bearish commentary would have underperformed equities by roughly 40% as the S&P 500, propelled more by earnings growth than by multiple expansion, rolled on...

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Promising Vaccine Data

Early last week Pfizer announced data on the clinical trial of their COVID-19 Vaccine candidate which was followed up this week by results from Moderna. It’s easy to see why there is so much excitement over the news as the reported 90 and 94.5 percent effectiveness would put the vaccine on par with the Chickenpox, Mumps, Polio, and Whooping Cough vaccine, and much further ahead than our typical flu vaccine. The logistics of distributing the vaccine will be difficult and likely take months but progress in the development aspect is hopeful.

The news comes at the same time that daily cases and hospitalizations are reaching all-time highs. We now have more clarity on what the end destination looks like (vaccine rollout and distribution in second half of 2021) but perhaps less clarity on the path as the spike in cases will weigh on consumer spending in the near-term. At the same time, with news of a vaccine we are likely to see economic growth accelerate going to into 2021. In short, this may end up being a W-shaped recovery. ..

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What to Take Away from Election Night

 

Although a presidential winner may not be determined until potentially the end of the week, one takeaway from election night is that the Republicans will likely keep control of the senate, meaning congress will be divided. This could be partially responsible for the large rally in equities following last night’s initial election results. Historically, equity markets have performed well in this environment with stocks being higher in the last ten years with a split congress. Although this election is far from over with a recount/legal challenge likely, a split congress actually adds some clarity as any significant legislative bill for either party will be difficult to pass. This includes a repeal of the 2017 Tax Cuts & Jobs Act which we wrote about in June and can be found here. ..

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Who's Winning the War on Cash?

Is cash still king? In the world of global payments, not so much anymore. Cash usage is at an all-time low giving way to the transformation to card/digital. According to the latest Nilson report, cash made up less than 20% of US payment volume in 2019 (by total reportable $ value), and is forecasted to fall to less than 15% by 2023. The demise of cash is one of the trends that has been in place for decades but has been accelerated by circumstances arising from COVID-19. The ability for card payments to now be administered in a contactless manner via ‘tap-to-pay’ has been a useful tool for consumers that want to avoid contact at the checkout aisle. Pair this with most consumer spending shifting to Ecommerce channels during quarantine and the demise of cash has been expedited.

The scale of the large pure-play payment networks, Visa and Mastercard, is staggering. Visa alone processes over 160 billion transactions per year totaling trillions of dollars in network spend. It may seem trivial to us as consumers to just swipe at checkout or place an online order using our debit/credit card but the logistics of what goes on behind the scenes is astonishing. The ability to instantly connect millions of cardholders to thousands of banks and merchants in 200+ countries is almost an impossible network to replicate. This decreased payment friction has also allowed cards to be used for smaller purchases that were once dominated by cash. Consumers in the past were hesitant to use their credit/debit cards on small ticket purchases but with the increased convenience of today's payment mediums that is no longer the case. ..

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Market Rotation

A historical blend of events in 2020 including the COVID-19 pandemic, shift to a work-from-home economy, and record low interest rates, created the perfect storm for large-cap US tech to structurally outperform the broader market. This outperformance has reversed in recent days with the S&P 500 falling 2.27% and the tech-heavy NASDAQ falling 3.25% last week. This sell-off might have been unavoidable given how stretched some of the valuations for the headline growth names have become relative to their historical ranges and profits began to be taken. It is difficult to see how operationally these tech companies will not continue to benefit as they have for so long, but in the near term a “catch up” rotation could be taking place in the market as the reopening of the economy accelerates, and those industries that have been decimated revert to the mean. In our previous blog post "Air Traffic Data Update" we highlighted how some industries were not seeing a stable recovery and that polarization still remains true today. However, recent economic data has come in better than expected boding well for those depressed industries to at least slightly ‘bounce’.

Timing a switch away from an area of the economy that has performed so well to those weakened alternatives is difficult. Still, an eventual mean reversion among valuations across the market is inevitable. Central Banks around the Globe have purchased over $1 Billion of financial assets every hour since the government lockdowns in March. This massive stimulus has coincided with a $1.5 billion increase in the Nasdaq 100’s market cap every hour. As long as this primary support pillar remains intact, owners of financial assets will continue to be the primary beneficiaries of monetary stimulus. ..

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Small Business Optimism Shows Quick Recovery

Although our investment holdings at Covington consist mainly of large multinational corporations, small businesses make up the backbone of the US economy. The most effective policies for defeating the virus are also the worst for small businesses (absent a vaccine). The mandatory shutdowns created a record number of “temporarily unemployed”  workers who were laid off but expected to return to work quickly. To help small businesses deal with this the government developed the PPP program to maintain their employment levels. This program was certainly not without its flaws, but all things considered, helped cushion the blow at least partially. The $600 additional unemployment benefits was also established. This did help buoy consumer spending but not in a proportional way to benefit small businesses as in lockdown most spending had to go through online shops. The $600/week supplement also created the problem of trying to rehire workers quickly as some low wage workers were now making more from unemployment benefits than they were while working.  

The good news is that these conditions are starting to dissipate as the economy slowly reopens. The NIFB recently released their June print for the Small Business Optimism showing a quick snap back from its plunge in March and April. This is encouraging but small businesses will continue to be dictated by the course of the virus and responses by our government.

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How Much Case Growth is Due to Increased Testing?

Cases continue to rise with the US registering its new daily record of over 70,000 cases on Friday. Deaths have also increased, but not with the same magnitude as case growth. The disconnect in deaths and cases is partially attributed to the continued ramp in daily testing. The US is now testing over 700,000 citizens a day. One of the attached charts shows the positivity rate (daily new positive tests divided by daily total tests) overlapping daily cases to show the relationship. The positivity rate gives a clearer picture of what the true infection growth is.  

Lawmakers look at this positivity rate in their respective states/counties as one of the key metrics to decide whether to relax, or tighten social distancing measures. If the infection rate is not tamed, it could mean that those industries most affected by shutdowns (Leisure and hospitality) will not be able to open. 

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Economic Fallout in Europe

The European Commission recently released their ‘Summer Forecast’ for the EU/Euro Area economy where they downgraded their own projection from earlier in the year. The original -7.4% GDP contraction expected for the EU economy has been reassessed to -8.3%. Even despite the swift and comprehensive policy response from the European Central Bank and EU governments, the lack of resilient technology giants like the US possesses, along with less diversified economies has hurt the European bloc proportionally worse. Also, social distancing measures were stricter in most EU countries meaning better virus control but worse economic damage to this point. Italy has shouldered the brunt of damage with GDP projected to fall 11.2% in 2020, while Sweden and Denmark are so far the least scathed projecting a < 5.50% decline.

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Not a Typical Recession

“This time it’s different” is a dangerous phase in the economics world. Recessions don’t typically result in personal income increasing, but this one has thanks to coordinated global fiscal/monetary support. However, soon the US faces a “benefits cliff” with the additional $600 per week of unemployment benefits set to end on July 31st and normal UI benefits for those who were part of the initial layoffs in March ending in September. Congress is expected to put together some kind of extension for these stimulus efforts but the two parties remain far apart on what exactly the next phase would look like. This stimulus is important because it has essentially buoyed consumer spending during the shutdowns. All income classes have seen their spending bounce significantly from the late March lows. But as we keep mentioning, stimulus efforts can only be temporary. Economies need to continue reopening and true economic activity needs to continue to regain its footing.

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Air Traffic Data Update

Certain industries/pockets of the economy are seeing a quicker recovery than others. The TSA keeps track of the amount of passengers originating trips from US airports. On a normal day in March that number is over 2 million, at the height of government shutdowns this year it was less than 90,000. Recently air traffic has recovered with daily passengers in the last week eclipsing 700,000, but this is still a long ways off from a “V-Shaped” recovery in air travel. Keep in mind airlines have high fixed costs, large amounts of overhead, and razor thin margins. Most airlines are simply not solvent if air travel is less than half normal traffic for a prolonged period of time.

We think this polarization in recoveries from one industry to another will continue and even worsen the longer the virus lingers in the economy. Some industries are seeing enormous demand tailwinds (Cloud, Ecommerce, Staple Goods) while others are still trying to claw their way back (Travel, Lodging, Restaurant Dining).

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COVID-19 Case Update

Cases fell slightly from their peak over the weekend but still remain high, particularly in the new “hot spot” states (Arizona, Florida, Texas). Many of these states have now imposed stricter social distancing guidelines after remaining relatively open during the pandemic. Even after 10+ days deaths have still not followed the increase in case load. The lag time window is not an exact number of days but this is still encouraging.

Commentary Disclosures: Covington Investment Advisors, Inc. prepared this material for informational purposes only and is not an offer or solicitation to buy or sell. The information provided is for general guidance and is not a personal recommendation for any particular investor or client and does not take into account the financial, investment or other objectives or needs of a particular investor or client. Clients and investors should consider other factors in making their investment decision while taking into account the current market environment...

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When Will Solvency Become an Issue?

US households have weathered the COVID crisis relatively well up to this point but there are two deadlines coming up for US consumers that could prove to stall out the economic recovery. On July 31st the extra $600 unemployment benefit per week as part of the CARES act will run out. Unemployment benefits normally last 26 weeks meaning workers who lost their job in March as part of the initial government shutdowns will exhaust all of their unemployment insurance benefits in September. Initial Jobless claims have fallen sharply from their peak but returning citizens to work may take longer than most are currently expecting. If more fiscal support is not extended to households by keeping the expanded unemployment benefits or implementing a fresh round of stimulus the risks will begin to rise that the US will experience a widespread solvency crisis in the household sector.

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COVID-19 Case Update (6/19/2020)

Although the nationwide COVID-19 infection rate has tapered off from its peak in April, different regions are at different points in their cycle. Coastal population centers in the Northeast look to be for the most part past their peak, while states in the West and Southern regions have seen their cases tick up recently. A second wave of cases is to be expected as societal activity continues to resume and widespread testing is being implemented. As we mentioned in previous notes, reopening will be a process. The graphic below, sourced from visualcapitalist.com, shows US states sorted by their COVID-19 peak dates. Also included is our US COVID-19 slides from our June Chart Book showing US & global trends.  We will continue to monitor these developments.

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Case Growth & Vaccine Development Update

In previous notes we mentioned the possibility of a “Second Wave” of cases popping up as activity resumes and social distancing measures are relaxed. In the last week cases have begun to rise across the nation, particularly in states that until recently have not seen a huge case load from the virus. The increase itself was to be expected but the severity of new case growth is still alarming. On June 26th the United States reported a new record in daily COVID-19 cases, most of which came from southern and western states. The encouraging sign from recent data is that so far daily deaths have not kept up with the pace of new cases. This implies that treatments are improving dramatically and testing remains robust. Keep in mind new deaths tend to lag cases so we remain hopeful that the fatality rate continues to fall.

Also encouraging is that households have remained very resilient even with very weak macroeconomic/employment data. The majority of consumers (77%) continue to think their own finances will get better or stay the same over the next six months. A lot of this is most likely due to fiscal and monetary assistance which has been very supportive, but a second round of stimulus aide may need to be enacted after current ones run out.

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What a Biden Presidency Could Mean for Corporate Tax Laws

Now that domestic COVID infection rates are falling, the country is beginning to reopen, and market volatility has subsided, it’s time to look ahead at what will most likely fill the media headlines in the second half of 2020: The Presidential election.

The stock market is surprisingly President-agnostic over the long term. Whether it is a Democrat or Republican, the President does not have too much direct effect on the stock market and companies learn to adapt quickly to the current regime. But this does not mean that the President does not have any influence over market factors. Presumptive Democratic nominee Joe Biden is much more centric than former liberal contenders Bernie Sanders and Elizabeth Warren, but he still shares some of the same policy directives such as the push for a return to the more progressive tax policies of the Obama administration. Biden has proposed partially reversing the Tax Cuts and Jobs Act (TCJA) passed by the Trump administration in 2017. This tax package in our opinion was a huge boost for American corporations not only because of the increased annual cash flow to the bottom line, but also the competitive dynamic compared to foreign nation’s tax rates. If the Biden Administration were to repeal this tax code it would be a headwind to American businesses. In a note put out over the weekend, Goldman Sachs illustrated how aspects of the TCJA being repealed would potentially affect large-cap companies bottom lines. Goldman’s Baseline forecast for 2021 earnings is slightly higher than consensus EPS estimates but their tax code revisions lowers them to in line with other forecasts.

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Job Losses Update

How Quickly Will Job Losses Recover?

This year’s huge job losses have almost been entirely attributed to the COVID-19 pandemic. This has played a huge role in why forecasters believe the vast majority of the losses will be temporary and the job market will see a quick snap back along with consumer spending buoyed by Ecommerce and fiscal support. The key question is how many of these jobs will never come back. It is also likely that many of these jobs may be restructured from shrinking industries into those which have seen their business growth accelerate due to the virus. These sort of shifts could create a drag on how quickly the nation returns to pre-COVID levels of employment.

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Acceleration of Ecommerce

When a pivotal economic event takes place like we are experiencing with the coronavirus pandemic there are certain trends that begin to either arise or quickly accelerate. We think the latter is currently happening with Ecommerce. It is no secret that for many years online shopping has been taking market share from brick and mortar retail. But never before have we seen a scenario where many brick and mortar retails were forced to close shop and deemed “non-essential”, while the large online market places became the essential way for consumers to get the goods they needed. Some could argue that Amazon & Walmart, the two largest Ecommerce retailers, became a staple of national security for their distribution capabilities as citizens are quarantined in their homes.

Much of this gained business is due to many small retailers simply being forced to close for several months, but we think that Ecommerce retailers will keep a good portion of the gained customers even after government shutdowns are lifted. In late April during Microsoft’s Q3 earnings call, CEO Satya Nadella remarked that “We have seen two years’ worth of digital transformation in two months” as Microsoft provides part of the digital infrastructure that Ecommerce retailers use. The graphics below show the dramatic penetration that online sales have reached along with the industry distribution due to this new world of the government forcing citizens to stay in their homes...

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Federal Reserve Action and Market Volatility

Federal Reserve Action and Market Volatility 

In late March the Federal Reserve established the SMCCF (Secondary Market Corporate Credit Facility) to support credit to employers and provide liquidity for financial markets.

These new credit facilities gave the Federal Reserve the ability to purchase a larger array of financial products than traditional quantitative easing techniques previously allowed. This included the ability to purchase large amounts of investment grade corporate bonds through SPVs (Special Purpose Vehicles).

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Quality Factors of Our Investment Philosophy

One central part of our investment philosophy that we constantly preach is owning companies that have strong balance sheets. What this means is that they have limited liabilities including debt on their balance sheets as well as low working capital requirements. We also look for those companies that have large amounts of cash on their balance sheets. When these strong balance sheets are paired with good capital allocating management teams future returns tend to be strong in both up and down markets. Goldman Sachs recently created “strong balance sheet” and “week balance sheet” baskets of stocks with the former outperforming the latter.

Strong Balance Sheets Outperform Weak Balance Sheets

Source: Goldman Sachs..

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What's Driving Equity Markets

What’s Driving Equity Markets

Fiscal response has been impressive and is a primary reason why markets have seen such a sharp rebound from their mid-March lows. In a note that came out last Sunday Goldman Sachs’ economic team wrote that “disposable personal income is likely to register slightly positive growth for the year” attributed to the stimulus payment program rolled out by the government has been so robust. This prediction is predicated on the passage of ‘Phase 4’ of the government's response so not a done deal yet. We think this forecast for disposable income to actually grow in 2020 is on the optimistic side but the fact that the government has seemingly been able to buoy consumer spending is one of the reasons for the sharp bounce back in markets in the last month...

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Covington Investment Advisors, Inc.
301 E. Main Street
Ligonier, PA 15658
Phone: 724-238-0151
Fax: 724-238-0148
Email: covington@covingtoninvestment.com

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