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Real versus Nominal post Covid and the Return of Active Management

Reacting to Recent Market Events

To most market observers, 2020 has been nothing short of bizarre. Not to say that certain hedge funds have not made a ton of money guessing correctly (more on that later), but we are in a time where there are around 400,000 deaths from the coronavirus (with 110,000 at time of writing in the leader of the free world, the United States of America) with no clear path to a recovery plus massive social unrest while the market continues to push on past all-time highs (and stocks were by historical metrics expensive before the coronavirus).

Oil prices (WTI) went to negative $40 a barrel and Renaissance Technologies, the trend following hedge fund that never loses, lost money because this was… badoosh… a black swan event!

We are also trying to make sense of the whole situation. While we did not sell out right before COVID-19 hit the U.S. in earnest, we have held on to our stocks and added to our positions during the bottom and made out quite nicely – so far.

We have some predictions on trends that will likely continue.

Quantitative Easing 2020 and Nominal versus Real Returns

Several governments who have their own currencies, namely the U.S., have applied massive stimulus to get the economy through the effects of COVID. So, while unemployment is high and productivity has slowed to a crawl in a lot of places (for example you cannot and probably should not be getting a haircut), the stock market has kept going up.

It does not make sense to a lot of people, but the prevailing sentiment from buy siders is don’t fight the fed.

That is one aspect to it. The market is almost back to even but purely in nominal terms. A dollar today is not worth as much as yesterday’s dollar because of the trillions in stimulus that have been injected into the economy. If we are producing the same amount of things – actually less – what this really does is erode the value of cash.

This pushes asset prices up in dollar terms. Stocks, houses, commodities – in theory, anyway. If you had a lot of money in savings accounts, boo you. The federal government purchasing bond ETFs also drives up prices.

With interest rates slashed while they were already low before, we know that from a discounted cash flow perspective this means that the present value of cash flows is now higher. This also means that asset prices should go up.

If an investor holds long term bonds, they realize an immediate increase in the bond price but if held to maturity the value erodes as inflation hurts fixed income instruments.

As the average investor, this means that stocks will continue to be the best way to grow or even just maintain wealth – as nervous people may be with today’s valuations.

We think this printing trend is going to continue. It is an easy cop out instead of looking at more structural issues in the economy. While the US, Canada and Europe have better institutions and frameworks whereby a hyperinflationary scenario such as in Argentina would be avoided, the credibility of their historically safe haven currencies may set up the rise of a liberalized Yuan as China has so far resisted the seductiveness of cheap money.

In the meantime, some speculators may flirt with the idea of gold and alternatives such as cryptocurrencies.

2020 is the Return of Active Management

Before the coronavirus, it seemed like the market was just going up fairly linearly. Longest bull market, low unemployment – buying the market and holding on to it was just fine.

Every day on Quora, financial advisors would pop up and remind us of the folly of trying to pick stocks when no one beats the market over a long enough time horizon.

Now we don’t think that this is false – after all, if someone beat the market over a long enough time frame they would eventually become the market. This is why Warren Buffett’s Berkshire Hathaway and other mega companies end up slowing down eventually. You simply run out of big enough opportunities.

In a growing economy, the inertia of Amazon, Google, Netflix, Shopify, Microsoft, Apple, Nvidia and AMD would have pushed a Vanguard Boglehead or Blackrock iShares investor along nicely to the tune of 12% a year for some time, backed up by the rest of the stock market which lagged these disruptors but still generated positive returns. It also helped that these tech giants snowballed to become larger and larger components of the indices, thus further enhancing investor returns.

However, in terms of the next few years, while Amazon and Microsoft, as well as hundreds of other cloud firms, continue to disrupt markets, a lot of companies with sound business models now have to address their viability in a new paradigm.

In addition, the economy itself is likely not going to grow – or at least at a much slower pace than where it was before. Given the sheer amount of debt in the market, there are plenty of capital structures and debt stacks that no longer make sense for many companies – especially ones in traditional retail, commercial real estate, travel, leisure and hospitality and many more.

After coronavirus, what is the valuation of a company such as Live Nation which relies so heavily on concerts and sporting events? Should StubHub undergo a rerating? What about Booking.com? What about airlines? What about cruise ships? What about casinos?

Even if they continue in some form, which we think they will, the reduction in traffic means a reduction in cash flow barring innovation.

So ultimately there are going to be winners and losers and a lot of asset managers are going to make money picking the right ones while the ones that pick the wrong ones will have to fold.

Just looking at a portfolio of Fidelity funds, and similar trends across other asset management firms is that wunderkind stock pickers that were marketed heavily by mutual fund sales guys (never trust them) are now quietly being tucked into larger and more successful funds after years of underperformance.

With the market having gone up as much as it has and the economy being stagnant, we can see the market being flat over the next few years – or at least not generating the same returns that we have become accustomed to since 2008. If this is the case and stocks such as Facebook keep going up, something is going down. The dispersion of stock returns will increase.

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Matt
ex investment banking associate
https://www.linkedin.com/in/matt-walker-ssh/

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