Q3 Letter - 2020
America has been through a lot over the past two weeks, and it’s almost the worst I've ever seen. It felt like being stuck in an episode of The Office, super awkward and uncomfortable. It's funny to watch on television, but living it was painfully embarrassing. It doesn't matter what your political affiliations are, the state of our nation over the last two weeks has left every American feeling painfully ashamed. I am deeply worried, as you must be, about our leadership and our future. In the financial markets, price divergences often tend to mean revert over time. I hope that our nation can follow that pattern and revert back towards one nation rather than diverge further into two parties. Because, once we endure this final round ahead, we will be tasked with rebuilding the future. It will be a better place if we build it together.
We’re entering the final round. Six months from today, we should be economically positioned to begin the next bull cycle. The two primary reasons are:
1) The second wave of COVID-19 will mark the second bottom of a W-shaped recovery
Public health experts anticipate a second wave of COVID-19 beginning in December and lasting into the 2021 flu season. Using Europe as a benchmark, and factoring in our lack of a coordinated national response, there is no indication we will fare better than them. I am confident our policymakers and business owners will be better prepared to handle the worst during this second wave. However, during the next six months, key portions of the country will re-enter shutdowns, making a double-dip recession unavoidable.
At the base case, the Oil & Gas, Retail, and Hospitality sectors remain deep in dangerous waters as they continue the slow drown in bankruptcies. There is a high probability that Chapter 11 filings will skyrocket as these sectors, already neck-deep in debt, are now submerged in additional stimulus debt with no chance for recovery in the event of a second wave. Also, we would not be surprised to see the Airline industry return to Congress a third time, pleading for additional stimulus. Worst case, cloud software companies who saw demand for their products skyrocket in May and June find themselves on the defensive due to a sudden evaporation in relative demand, as everyone who needs their product already bought it 12 months ago, leaving their CEOs hard-pressed to justify their extended valuations. This V-shaped recovery will quickly look like a W, but from an economic and humanitarian perspective, it is here that we will have reached the true bottom.
2) Vaccines are on the way
News headlines tend to highlight only a handful of COVID-19 vaccine candidates. But, in reality, there are more than 150 vaccines currently in development worldwide, and nine of these are in Phase III trials. In fact, Russia and China have already begun offering vaccines to their general populace.
(The vaccines these two countries have developed are categorized as "inactivated vaccines." This type of vaccine consists of a dead or inactivated form of the COVID-19 virus. Because the virus is inactive, these vaccines are generally considered safe. However, this safety comes at the cost of efficacy. A vaccine that uses an inactivated virus may not elicit a sufficient immune response capable of thwarting the virus. On the other hand, the vaccine candidates in the US are "attenuated vaccines." These vaccines consist of a weakened, live form of the virus. Since these are live cultures, they are generally successful at eliciting an immune response but must be rigorously tested to ensure their safety.)
An available, effective vaccine in the US market will result in the gradual resuscitation of business activity, generate an increase in overall sentiment, and put us on a path to normalcy.
As far as the economy is concerned, these should place us on the threshold of the next bull cycle. However, I am concerned that this economic positioning will not translate well into continued stock market gains. We have witnessed the stock market diverge from the real economy over the past six months and grown numb to these straight-line gains. This phenomenon could very well reverse over the next six to twelve months.
Inflation, Pesticides, Fertilizers, and the Price of Milk
Inflation is an enigmatic and tangible force in the financial markets. It is difficult to control as it drifts in and out of different assets at various times while affecting different groups of people in a variety of ways. Its effect on the broader economy is felt along a bell-shaped curve – not enough inflation and economic growth will suffocate, too much and it will drown.
To demonstrate this second point, imagine a new pesticide-resistant insect wipes out the orange groves throughout southern Florida. As a result, the trees yield zero oranges this season and the few cartons of remaining orange juice, normally priced at $2.99/carton, now sell for $12.99/carton. To adapt, the consumer is forced to purchase more milk. In turn, the demand for milk soars, inflating the price from $3.99/gallon to $13.99/gallon. After nearly a year of buying milk at an artificially high $13.99/gallon, the orange growers have developed an effective pesticide bringing the insects under control. They also stimulate the soil with extra nitrogen to ensure a rebound in orange yield. Subsequently, the orange yield recovers and now the grocery store's orange juice inventory is overflowing. This overwhelming supply pushes the price of orange juice down to $1.99/carton. Before, you had no alternative but to purchase milk at $13.99/gallon, but now you have an alternative option – milk at an inflated $13.99/gallon or orange juice at $1.99/carton. Drowning in orange juice, what happens to the price of milk?
Inflation Expectations, Vaccines, Stimulus, and Too Much Juice
Our forecast for the next six months includes two events we anticipate with a high degree of certainty.
1) A COVID-19 vaccine for the domestic market will be ready.
2) Washington will pass a $1.5-2.5 trillion fiscal stimulus package.
Short of money raining down from the sky, there is nothing between now and March that would be more inflationary than these two events occurring at the same time. Just like pesticides and nitrogen, this combination will resuscitate inflation expectations and turbocharge long-dated treasury yields as investors engage in what may be the largest dump of safe-haven and risk-off assets in history. Coming out of any other recession, that would be a good thing for stocks. However, with equity valuations as high as they are, I am concerned the market will drown in higher yields this time around.
Who is to blame for this predicament we are currently in? The Fed’s playing fast and loose with the money supply, the Trump administration's inaction to the spread of COVID-19, the left's radical shutdown methods, the flood of Robinhood day traders bidding up single options contracts. I can go on. Regardless of how we got here, we are faced with the reality of a stock market dangerously disconnected from the state of the real economy, and something must give.
Returning to our analogy, the price difference between milk and orange juice under normal market conditions was $1.00. The stock market today is the milk at $13.99/gallon, and it is priced at this level because the orange juice, treasury bonds, are selling at 100-year highs with yields nearing 0%. The stock market is trading as if orange juice will be priced at $12.99/carton, forever. Fortunately for humanity, but unfortunately for stock prices, this will not last forever. The combination of a vaccine and fiscal stimulus will catapult treasury yields, and orange juice will print next season at $1.99/carton. There’s no question, the economy is better off with both options back in play, but in the short-term, what happens to the price of milk?
Market Spreads Are Underpricing Risk, Positioning for Uncertainty
Below we have charted the historical difference between stock market valuations and treasury yields. The difference today is as small as it has ever been over the past decade. Thus, when the yields rise, and the juice suddenly sells at $1.99 instead of the current $12.99, something will have to give. I do not know what that 'give' will look like - will it be a concentrated pullback like March of 2020, rolling bouts of volatility like 2018, or a multi-year bear market like post-1929? It's hard to say.
We predict this 'give' will have a broad, non-uniform effect across sectors and companies. For example, companies with the highest valuations will face the greatest headwinds once investors are forced to recalculate their cost of capital. At the same time, value sectors, like travel and entertainment, might see an initial pop and squeeze accompanying the rise in vaccine sentiment.
You may have noticed more changes than usual in our strategies over this past quarter. We are evaluating our allocations and seeking to strike a balance between the effects of this 'give,' the current state of 0% yields, and the slight chance that six months from now, the Fed engages in yield curve control, the outright purchasing of long-dated treasuries to suppress the yield curve – something they've explicitly stated that they will not do. We are also working to determine the level of downside protection appropriate for each strategy. We believe it is optimal to buy insurance before time of uncertainty, as insurance is always the cheapest when the world believes everything is going great. It just so happens, the stock market is holding large rallies, planting lawn signs, and attaching bumper stickers upon which is printed in bold letters – EVERYTHING IS GREAT AGAIN.
I want to receive Mirador’s research and market updates!
Information presented reflects the personal opinions, viewpoints and analyses of the employees of Mirador Capital Partners, LP, an SEC-registered Investment Adviser. The views reflected in the commentary are subject to change at any time without notice. Nothing herein constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Mirador Capital Partners, LP manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results. Visit us at miradorcp.com for more information.