Economic recovery, yes, but it’s a tricky definition

The biggest financial risk now is over-concentration on a handful of leading US stocks.

The market appears almost single-mindedly optimistic and a bull market is often characterised by its ability to climb a wall of worry. Picture: AFP

Wall Street’s S&P 500 index has now risen about 36 per cent from its March lows and despite the unlikely event of a full recovery to pre-crisis levels of activity any time soon, the S&P 500 has now cut its losses for the calendar year to just 6 per cent or so at the time of writing.

In Australia, a camp full of seasoned investors sees dark clouds on the horizon and concludes a V-shaped recovery is doubtful, pointing to lasting impacts from the COVID-19 crisis, including higher unemployment, small business contraction, lower population growth and weaker confidence.

But the market appears almost single-mindedly optimistic and a bull market is often characterised by its ability to climb a wall of worry.

The idea of limitless fiscal and monetary policy stimulus must be considered because unless there is a meaningful second wave of infections, the reopening data in Australia, and importantly, in the US, is emerging better than expected.

In mid-May, former treasurer Peter Costello observed, when referring to the stockmarket’s optimism, “Markets have decided the crisis is over. I’ve got to say, it’s a pretty optimistic view that it’s all over now.”

Importantly, there is a difference between Costello’s definition of a recovery and the one held by the market.

If a recovery is something like a boxer standing up off the mat after being KO’d, then we are, economically, well and truly in a recovery. If, on the other hand, the definition of a recovery is a return to full strength and prior levels of economic activity, revenues and profits, then we are a long way from it.

Both are simultaneously true: we are in a recovery and yet we aren’t going to recover.

Facebook, Amazon, Apple, Netflix, Google, Intel, Nvidia, and Cisco have increased their market cap by almost $US1 trillion ($1.44 trillion). This is triple the total gain of the remaining 2990 companies.

Concentration risk might yet be a bigger issue than any other black swan.

Share prices have been rotating - admittedly mostly upwards - around four factors: government health initiatives and responses, the economic impact of those initiatives and responses, the fiscal and monetary policies to combat those economic impacts, and the prospects for a vaccine or treatment.

However, the key driver of higher markets amid potentially poor economic prospects is what we call The Fed Put - central bank buying of assets to support prices while simultaneously destroying natural price discovery.

Optimistic, or not

Barron’s recently revealed just 39 per cent of US fund managers were bullish on the equity market for 2020, while 20 per cent were bearish and the remainder - the 41 per cent - were neutral. This is despite the fact that the S&P 500’s first quarter earnings are expected to fall by almost 10 per cent, before falling even more in the second quarter. But Barron’s also revealed that nearly 85 per cent of fund managers were bullish on the prospect for equity markets for next year.

Perhaps the only danger is the possibility of a second wave of infections that forces another round of lockdowns.

As the health risks abate, the derisking that occurred ahead of the virus’s spread will reverse and eventually be completely unwound.

What will remain are idiosyncratic opportunities.

For investors there will be many companies that emerge stronger than they entered the crisis.

Those whose equity was not diluted by capital raisings, those that will return to an environment with weakened or reduced levels of competition, and those that will enjoy a surge in sales from pent-up demand and the support from fiscal and monetary policy, will be favoured by investors still looking over their shoulders for black swans or fat-tail risks.

Roger Montgomery is founder and chief investment officer of the Montgomery Fund.

www.montinvest.com