The stock market as represented by the major indices has regained 50% or more of the precipitous drop that unfolded from mid-February into late March. The rebound is almost certainly due to the Fed’s massive injection of liquidity in order to mitigate the impact of one of the most sudden economic contractions in U.S. history, spawned by a worldwide pandemic that has brought economic activity to a virtual standstill.
There is a huge debate underway about the sustainability of the advance. Those who believe the March 2020 bottom will not be retested make the case that historically high valuations are justified, despite the certainty that consumer spending and corporate earnings will suffer a significant contraction during the coming months. However, without government assistance many marginal companies will struggle to stay afloat. As unemployment soars, many families who are short on liquid assets will struggle to meet their daily obligations. State and municipal governments will also need Federal assistance, given the enormous contraction in tax revenues. Under such conditions, a further advance seems a tall order indeed.
As would be expected, there has been a much more muted rebound in high-yield debt securities, which are the focus of Kensington’s Managed Income strategy. These securities are particularly vulnerable to default or credit downgrades by the rating agencies. Although the Fed has introduced measures to specifically support some sectors of this market, the extent of that support is uncertain. And regardless, it is unlikely to be sufficient to avoid significantly greater weakness if a resumption of economic activity is delayed beyond the next few months, which appears likely.
Societal restrictions are now being lifted to varying degrees in some locations, but economic activity will undoubtedly be at far lower levels than normal for months to come. Even in a best-case scenario, it’s hard to imagine that currently high market valuations can be sustained in the face of a moribund economy and increasingly negative economic news. On top of this, there could be a resurgence of infections as a result of those loosened restrictions. The next few weeks should give us clarity on what to expect.
Turning to the Managed Income model, it is flashing warning signs right now because of the disconnect occurring between a strong equity market and lackluster high-yield bond prices. Healthy markets are characterized by strength in both asset classes simultaneously. When these markets are out of synch, the model is less likely to assume a “risk on” posture. Consequently, patience is warranted. If our expectation of substantially lower prices ahead is borne out, that patience will be rewarded with an exceptional buying opportunity.
In the meantime, we are in capital preservation mode being invested in shorter term Treasury securities and will rely on the Managed Income model to tell us when it’s a safer time to re-enter the market.
Bruce P. DeLaurentis