Here’s the news of the week – and how we see it here at McAlvany Wealth Management:

Déjà vu or a Bump in the Road to Riches?

This week, the reopening trade and the initial ebullience we’ve seen in the capital markets over the last several weeks have come under significant pressure. Concerns have mounted that a rise in COVID-19 “cases” will lead to additional shut-downs, additional economic pain, and any prospect of an earnings recovery pushed further to the right. 

This week’s 2.86 percent decline in the S&P 500 highlights exactly how fragile and tenuous economic sentiment remains. Naturally, sectors most leveraged to a successful reopening of the global economy were hit hardest, including airlines (off 10 percent), oil (off 11.3 percent), and hospitality stocks (off 13 percent). “Stay-at-home” stocks were big winners for the week as impacted jurisdictions began to stall or in some cases walk back their reopening plans.

The incredible 41 percent rally we saw from the March 20th lows was quite incongruous with 40 million American workers unemployed and a global recession. As the economic data became worse and the market continued to rise, it was clear that the risk/reward ratio was increasingly unfavorable given the dramatic disruption to the economy.

In thinking about investing, long-term perspective is helpful here. While it is true that there is some percentage of lost profits that will not return, most of the “lost” earnings we will see are actually simply deferred. In thinking about valuation of a company, near-term cash flows have a more meaningful impact than longer-term cash flows due to the time value of money. However, much of a company’s value is actually in its “terminal value,” or the long-term growth rate of cash flows as the company matures.

While this may sound like an academic exercise in valuation, our point is that the intrinsic value of a company is not measured in months, it is measured in years. As long-term investors, this is what we must always remember to keep in focus. We must continue to ask ourselves “is this transient, or is this a permanent impairment of the business? What the markets told us in the swift bounce we saw over the last few months was that perhaps COVID-19, while severe, is ultimately transient. We very much look at this on a company-by-company basis.

The most lasting effects of COVID-19 may indeed be in policymaking and how the Federal Reserve interventionist policy of emergency cash infusions, asset purchases, balance sheet expansion, and negative real interest rates flooding the financial system with liquidity will impact the financial system over the long run. Although clearly good for asset prices in the short-run, the long-term effects of money creation are unknown. The theory is always that policymakers will know exactly when to reverse course. However, given the failings of policymakers in other areas, we view this assumption as dubious.

We think there is a PhD thesis lurking in the question of “how do negative real interest rates and dollar devaluation impact the weighted average cost of capital, discount rates, and company valuations?” Or at least a very dry book in the overcrowded realm of valuation analysis. We must also bear this in mind as we think about what a dollar in future cash flows really means. Perhaps we must use a higher discount rate to discount cash flows if the value of those dollars is inherently unstable. These are the kinds of musings that will likely get you kicked out of your finance and economics classes in modern universities.

The reopening process was bound to be met with fits and starts, and a “second wave” would have been very difficult to avoid. Anyone who has dealt with just about anything in life, whether it is running a business, trying to grow a career, or falling in love knows that paths to success are often a series of non-linear events. We are still learning much about this virus and what sorts of precautionary measures are needed in order to have maximum safety. Heavy public debate, seemingly split down party lines and political aisles rather than science-based discourse, continues in the media as it does in the capital markets. One size certainly does not fit all in fashion or the reopening of America.

Best Regards,

David McAlvany
Chief Executive Officer