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Strategy Update

Fear and Euphoria

Against a backdrop of dour headlines, the stock market rallied through the second quarter. It is hard to recall a time when enthusiasm reflected in the stock market contrasted so sharply with news about the economy and the state of the country. Fear turned to optimism, and in some sectors outright euphoria, in a matter of months. An alarming number of current investment anecdotes recall the spring of 2000 and the technology investment bubble. What started as fairly rational buying of the largest tech names has morphed into rampant speculation in companies that mirror or mimic the leading tech companies. Some of the hottest stocks in the current market were not even publicly traded last year, have never produced a product, and perhaps never will.

To better explain the performance of the major market indices, we can divide the stock market, and the economy overall, in two. Companies perceived to be “new economy,” technology-driven enterprises are strongly in favor with investors. Most others, thousands of companies that represent much of the U.S. economy, are either falling in value or gaining very little. Through the second week of July, the Russell 2000 Index, a list of 2000 smaller to medium size companies that typify the U.S. economy, was down 14% on the year. This is not surprising, given that the country is suffering through a recession with tens of millions unemployed. On the other hand, the NASDAQ 100, a much smaller selection of predominantly technology companies, was up 25% on the year. This is in part because its member companies are designed for a stay-at-home and work-at-home world.

The dichotomy in the market has reached extreme proportions. Amazon’s valuation has grown to $1.6 trillion, and is now larger than all other publicly-traded retailers in the country combined (a list that includes Walmart, Target, Best Buy, and dozens of other retailers). While Amazon is thought of as a technology company, the others are seen as simply retailers. Another example is Tesla, which is estimated to produce one half of one percent of cars globally, yet is now the most highly valued car company in the world. Its valuation exceeds the combined value of GM, Ford, Honda, Subaru, VW, Nissan, BMW, and Mercedes. Investors have decided that Tesla is in the “new economy” tech group, while all other auto companies are simply boring auto makers. We admire the technology that has gone into producing Tesla cars, the best electric cars on the market. But we do take issue with the valuation of Tesla stock, which seems to know no bounds. Elon Musk himself said that Tesla stock was overvalued at $750 per share, but that has not stopped traders from pushing the stock to twice that price.

Amazon and Tesla are examples of substantive companies whose valuations have potentially reached an extreme point. Below their ranks are many companies whose shares exhibit an even greater degree of euphoria. Nikola, a company with only a prototype and a stock that began trading in June, reminded investors enough of Tesla that its shares doubled in a few weeks. Another company, Tiziana Life Sciences, has seen its shares rise nearly 600% since March. In the absence of significant news, one might speculate that the reason for this climb is the fortunate ticker symbol TLSA, which is quite similar to Tesla’s TSLA. Perhaps some traders are just entering the wrong symbol in their haste to buy Tesla.

Investors who were fearful just a few months ago have decided to vastly increase risky stock market bets. There is one simple cause that is most likely at the root of the buying. In an attempt to bolster the economy, the U.S. Government and the Federal Reserve have injected massive amounts of money into the financial system. The money supply in the United States has grown by $3 trillion in just two months. Any stimulus that is not spent becomes savings, and savings in turn become investments of one form or another, whether deposited at a local bank or used to day-trade in the stock market. In a twisted irony, the complete bungling of the Covid-19 pandemic response in the U.S. has led to an increased need for massive financial stimulus, which in turn has fueled the stock market rebound. Pushed into a corner by near-zero interest rates and a recession that is crippling many businesses, investors decided the biggest tech stocks were the safest haven for funds. It was a reasonable idea, and through April and May it was one that we shared. However, good investment ideas can quickly become crowded trades, with many investors piling into the same small number of companies. And with too many investors pursuing the same stocks, these good ideas ultimately turn into dangerous investment holdings.

Current Strategy

Many of our share purchases in the second quarter consisted of technology and consumer staples companies. In both cases we sought to invest in companies we thought would be relatively immune or insulated from the effects of a more lasting economic shutdown. We also selectively sold shares in companies we thought would have more pronounced difficulties in a recession. Given the spate of economic problems companies are facing, however, and how stretched valuations have become on technology companies, we think it is important to remain cautious. While negligible yields make it wholly unrewarding to sit on any cash, we believe that is the correct thing to do in this market. We are shifting our focus from pursuing potential gains in a low stock market to preserving gains in a market that feels elevated.

The corporate bond market collapsed in March, alongside most other asset classes. Since that point nearly all bonds have rallied ferociously, with investors emboldened by the full support of Central Banks around the world. Our existing bond holdings have rallied, and the corporate bonds we bought in the depths of the market decline in March have since risen in value. The problem now is that yields are negligible wherever one looks, and few bonds offer a rate of return that even exceeds inflation. The gyrations in March are a reminder that conditions can change unexpectedly. Rather than commit to long-term bonds with what we view as poor yields, we think it best to stay on the sidelines for now and wait for better opportunities.