Novum Digital Asset Alpha - Daily Analysis 19 August 2020
What a wonderful Wednesday it's turning out to be for investors as I hope that it is for you as well!
In brief (TL:DR)
In today's issue...
Nothing quite screams "Happy Hour" than a new record for the S&P 500.
Lead primarily by tech stocks, the S&P 500 rallied to a new record on the back of massive stimulus injections from the U.S. Treasury department and the Federal Reserve.
And while Congress twiddles its thumbs on a fresh round of stimulus measures, better than expected economic data and corporate earnings are fueling optimism that a recovery is taking shape.
Asia joined the party, with Tokyo's Nikkei 225 (+0.28%), Seoul’s KOSPI (+0.49%), Hong Kong’s Hang Seng Index (+0.08%) and Sydney’s ASX 200 (+0.82%) all up.
And there are hopes that a stimulus package out of Washington may just arrive with House Speaker, Nancy Pelosi indicating that the Democrats may cut the size of their stimulus proposal in order to close a speedy deal with Republicans for urgently-needed relief for Americans.
1. If An Index Is Supposed To Represent the Economy, Is the S&P 500 Broken?
A weighing scale with the butcher's thumb pressed down on it won't tell you how much your meat is really worth.
And like a scale that has been artificially skewed, the S&P 500, long viewed as a broad measure of the American economy, has become more unrepresentative than ever.
Despite American stocks only closing a fraction higher yesterday, the S&P 500 set a new record and has capped a powerful, if uneven rally, fueled primarily by central bank stimulus.
Although more stocks of the S&P 500 fell than rose, the gains chalked up by Google (+2.68%), Amazon (+4.09%), Apple (+0.83%), Microsoft (+0.58%) and Facebook (+0.45%) were enough to help the S&P 500 erase all losses from the coronavirus pandemic and set a new record close.
The five tech firms now represent more than 20% of the value of the S&P 500, the highest in almost four decades.
For investors who buy indices, the S&P 500 is inching ever closer to the Nasdaq Composite, a tech-focused index.
The S&P 500 today has a much smaller weighting to the areas of the American economy most badly hit by the coronavirus pandemic, including hospitality, airlines and retail.
And while buyers of the S&P 500 may cheer, it also risks the index becoming over exposed to the technology sector.
As a reflection of a broad swathe of the American economy however, the S&P 500 may be broken, with record divergence between winners and losers that has benefited tech firms that dominate the digital economy such as cloud computing and online shopping.
On the other hand, it could be argued that the S&P 500 is merely reflecting trends that were already in the offing well before the coronavirus pandemic.
Could the S&P 500 then be overweight and more importantly, overpriced?
Depends really on what you're measuring it against.
Stocks have rallied with trillions of dollars in government spending and support from the U.S. Federal Reserve, which cut interest rates in March to near-zero, and announced a vast bond-buying program to support financial markets and help companies borrow money to survive the pandemic.
But the subsequent rally in U.S. Treasuries also sent the yield on the 10-year bond, a benchmark indicator for risk and normally used as a hedge against stocks, to record lows this month as well.
Under normal market conditions, whatever that means now, bonds typically move in the opposite direction to stocks.
But because bonds rose with stocks, yields have come down and pushed investors to seek higher returns in riskier assets, for which the S&P 500 is meant to be a benchmark, and made stocks look less expensive relative to bonds.
And even though the S&P 500 rallied to set a new record, the earnings yield on U.S. stocks - a measure of profit relative to share price - is only marginally higher compared to bond yields, than it has been historically - meaning from that perspective, they're not too expensive.
Which may be why stocks are so "expensive" right now from a price-to-earnings perspective.
Massive amounts of central bank stimulus have depressed fixed income yields so much that stocks don't look expensive in real terms, relative to bonds.
And in that sense the S&P 500 isn't broken, it's reflecting an economic reality that clearly is.
2. Are Commodities The Next Best Bet?
Craig Stephenson knows very little about commodities, but on any given day over the past summer, he could be found devouring books on oil extraction and pouring through the annual reports of energy companies.
A money manager, Stephenson, like dozens of his counterparts have long relied on a blend of stocks and bonds to deliver consistent returns to their clients.
But a market which has overturned traditional stock and bond correlations and undermined years of expensive lessons learned in the oak-paneled walls of business school classrooms, has made gamblers of us all.
As stocks have become increasingly pricey and the holding cost of bonds has skyrocketed, more money managers than ever have dipped into the volatile markets for commodities, in search of both yield and a hedge against inflation.
Assets under management at commodity funds have jumped to US$570 billion, their highest level in almost a decade.
And while much of this increase can be attributed to money entering the gold market, investors are also pouring into oil, industrial metals and agricultural products, according to analysis from Citigroup.
Unlike stocks, commodities more closely reflect economic activity.
And lingering doubts over the pace of global economic recovery has so far put a lid on industrial commodities like copper and oil, which are still well below their recent peaks, given their reflection of construction, manufacturing and transport demand.
Now that the S&P 500 has hit a new record in what ought to be the worst economic conditions facing the United States since the Great Depression, some investors are betting that commodities will play catch up to both stocks and bonds.
Investors are betting that raw materials will fare well if the Fed's efforts to revive the economy inevitably stoke inflation, even though market measures of inflation expectations, although higher, are still well below historical highs.
There is also a group of investors pouring into commodities because of the view that they are detached from the international financial flows that drive more mainstream markets.
According to that view, commodities provide a cushion if stocks nosedive, a role which bonds may struggle to fulfill in another crisis, since they are already so expensive.
Given how normal market correlations have been distorted, there may be more than an ounce of gold in these investment theories, especially against a backdrop of a longer term decline in the dollar.
Investors who had thus far stuck closely to a 60/40 stock/bond portfolio split may want to consider diversifying their portfolios for some small exposure into commodities as well, especially given that many pension funds are already doing so.
Because if bonds are not the buffer to stocks, what is?
3. Goldman Sachs Has A Change Of Heart When It Comes to Cryptocurrencies
"It doesn't matter if a cat is black or white, as long as it catches mice."
- Deng Xiaoping
The same could be said about bankers and their attitude towards any asset class. Ultimately, as long as it makes money for the bank, the asset is just a vehicle that gets you there.
So it shouldn't surprise when JPMorgan Chase (-1.39%) created its own JPM Coin despite repeated criticisms of Bitcoin by its CEO Jamie Dimon.
Or that Goldman Sachs (-0.87%), which revealed in a much-hyped investor call in May this year, why Bitcoin and cryptocurrencies shouldn't be considered an asset class, has now had a change of heart and appointed a new global head of digital assets.
Ultimately, when it comes to banks, they'll go where the money is.
And given the unprecedented fiscal and monetary stimulus spewing out of central banks, the money is everywhere.
Following in the footsteps of JPMorgan Chase, Goldman Sachs is now allegedly exploring the possibility of creating its own blockchain-based response to Bitcoin.
In an interview with CNBC this week, Goldman Sachs head of digital assets Matthew McDermott said,
"We are exploring the commercial viability of creating our own fiat digital token, but it's early days as we continue to work through the potential use cases."
McDermott also revealed a growing interest from clients towards cryptocurrencies, adding,
"We've definitely seen an uptick in interest across some of our institutional clients who are exploring how they can participate in this space."
And Wall Street will give clients what they want.
In the sense that Bitcoin and most other cryptocurrencies track very little by way of underlying assets, outside of the very blockchain protocol upon which they are built, cryptocurrencies in particular, lend themselves perfectly to Wall Street-fueled excess.
The very definition of an unconstrained asset class, cryptocurrencies provide Wall Street the perfect opportunity to lean into many of the bad habits that have otherwise (more or less) been routed out of the mainstream financial markets.
Some of that behavior, including front running (putting proprietary trading desk orders ahead of clients), spoofing (artificial demand and supply) and wash trading (generating fake volumes) are already common place in the cryptocurrency market, Wall Street will supercharge that behavior.
But it will also generate huge amounts of profits for investors, traders and yes of course, the banks themselves.
The last financial crisis was born of the massive boom and bust of unregulated and virtually un-understandable derivatives tied to credit instruments, of which credit default swaps, collateralized debt obligations and mortgage-backed securities were just some of them.
In the coming age, unconstrained assets like Bitcoin and a host of other cryptocurrencies could see Wall Street layering on all manner of exotica on top of them as well.
And while that may make for good profits for the banks, it's normally the retail investors who will ultimately be left holding the bag.
While the color of the cat may not matter, who the mouse is should.
And if retail investors are unsure of who the mouse is, it's probably them.
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Aug 19, 2020
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