Newsletter – Quarter 2, 2020

In the world of investing, we are often told to be cautious when we hear market participants use the phrase “this time is different.”  The phrase is often used to justify some excess in the market.  For example, during the Dot-Com bubble of the late 1990s, the phrase was used by investors to justify paying sky-high prices and valuations for money-losing businesses.  Eventually, economic reality returned and left many of these investors holding the bag.  

The market’s strong performance over the past three months, despite many uncertainties about the economy, has many in the investment community questioning what is fueling the rally.  Will there be a faster than anticipated economic recovery, or has the constant fiscal and monetary stimulus distorted price discovery and the market’s ability to act as a discounting mechanism?  Historically, times of great uncertainty and future economic risk have typically led to lower valuation multiples.  Clearly there are a lot more uncertainties in today’s economy than usual.  Yet today’s valuations seem to paint only a rosy outlook.  Just to list a few:Will we see a second wave of the virus in the fall? 

  • Will an effective vaccine or therapeutic be developed? 
  • When will businesses return to pre-Covid levels of operation? 
  • How many of the temporary layoffs will become permanent?
  • What impact will November’s elections have on taxes and regulation? 

Despite these difficult-to-answer questions and their potential impact on business fundamentals, many stock market valuation metrics are near all-time highs!  Given this large disconnect between Main Street and Wall Street, we begin to ask ourselves, “Is this time different?”

We do think there is a case to be made that market valuations should be viewed differently than the past primarily due to the Federal Reserve’s growing presence in the market.  A significant certainty during these uncertain times has been the Fed’s willingness to intervene in the marketplace to help support the market.  In fact, the Federal Reserve has made a habit of injecting liquidity into the market for over a decade, pushing interest rates lower, with a corresponding move higher in valuations.  In addition, it has signaled no intention of pulling back anytime soon.  If the Federal Reserve is willing to backstop the market whenever it experiences a significant drop, then it makes sense to pay a higher valuation for a “less” risky asset.  It also makes sense to expect lower future returns when buying at higher valuations.

The questions we grapple with today are: What are the limits of the Fed’s accommodative policy, and at what point will it become ineffective?  The Fed still has plenty of tools at its disposal, including the manipulation of the yield curve, negative interest rates, and buying equities.  Other central banks have used similar practices for many years, so we have a rough road map for such measures.  Yet it is impossible to know when these tools will become ineffective.  Is it in a few years?  Multiple decades?  No one really knows. 

Thus, we have thought a lot more about constructing portfolios that play a good amount of offense and defense.  A portfolio’s offensive side, primarily through owning equities, will participate in the upside as the Federal Reserve continues an effective campaign of keeping the markets happy.  The portfolio’s defense will come in multiple forms, such as owning uncorrelated asset classes, maintaining adequate liquidity via cash and treasuries, and limiting or avoiding areas we feel have troubled fundamentals.  An additional layer of defense can come from proper financial planning.  If one’s investment goals and time horizon allow for less risk taking, then it is best to take advantage of recent market strength and de-risk one’s portfolio.  While today’s investment environment may be different than the past, we are confident that prudent security selection, portfolio construction, and financial planning give our clients the best opportunity to reach their financial goals.


Gamble Jones Investment Counsel

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