Contrary to the chorus of doomsayers, who earlier this year posited that the stock market would take years to recover from the negative economic impact of the COVID-19 pandemic, the year-to-date damage to the market has been largely repaired. The reason so many got it wrong is because they believed the recovery in corporate earnings as well as the recouping of record job losses would take much longer than a few months or quarters. Even economists with the most optimistic forecasts do not envision a rapid return anytime soon of the record low unemployment rate posted earlier this year.
In my view, the coordinated fiscal and monetary stimulus actions have been the primary reason for the rapid recovery in stock prices. Interest rates are at historic lows. This is compelling investors to move into higher risk categories in order to generate reasonable cash flow from their investment portfolios. Near-zero interest rates present a particular conundrum for senior citizens who need to supplement lower retirement income streams.
Many pundits now view the stock market as well-underpinned by the massive quantities of cash on the sidelines. A CNBC report last week stated that despite the stock market rally, there is still a whopping $4.6 trillion of cash sitting in money market investments waiting to be deployed. This compares to the $3.6 trillion at the end of 2019. Many investors are opportunistically looking for market weakness to put some of that money to work.
So, I do not envision a significant retreat in the stock market should the economy remain on a steady path to recovery. That said, there are always a myriad of potential risks in the market. I would like to suggest a few scenarios that could upend certain sectors of the market. I believe these scenarios should be considered when contemplating an investment strategy for the remainder of 2020 and beyond.
A Second Wave of the Virus
Many epidemiologists believe that there is a meaningful risk of a resurgence of the virus later this year. Should that occur, and the government again responds by substantially closing down the economy, it could present an existential risk to the viability of highly leveraged, cyclical companies. I am particularly wary of the potential impact on the airline industry. Many large industry players have already taken on significant amounts of debt to manage through what is expected to be a long and gradual recovery. Shareholders of airline stocks have already experienced much pain in 2020. But a new wave of the virus could force many of these companies into bankruptcy, which could entirely wipe out airline investments.
Scenario #2: The Federal Reserve Loses Control of Interest Rates
Since the financial crisis, the Federal Reserve has been wildly successful in managing and controlling interest rates. The magnitude of the Fed’s financial alchemy has created an environment in which the economy can recover from crises and dislocations. But it leaves investors in uncharted territory with regard to the Fed’s ability to maintain that control over the long term.
Several years ago, I spoke to a renowned hedge fund manager at an industry conference. He raised the concern that the Fed historically indeed has lost control of the interest rate market. Older readers know that this phenomenon occurred in the late 1970s and early 1980s. Reacting to growing inflation, fixed-income investors walked away from the bond market, causing interest rates to soar. The damage was felt in many market sectors dependent on low interest rates such as real estate and automobiles.
Scenario #3: The Economy Recovers Too Quickly
Now that does not sound like a big worry from a health standpoint. But a rapid recovery could lead to the possibility of rising inflation and interest rates. While higher interest rates could prove beneficial for bank stocks, sectors that have earned high valuations from the shelter-at-home economy could be vulnerable. Without providing specific names, there are a number of stocks whose prices have soared to levels that can only be justified by the combination of high long-term growth rates along with a low interest rate environment. An acceleration of the economic recovery could cause investors to take their profits and run.
We live in a world of heightened levels of risk in the wake of the pandemic. This fact compels investors to take a hard look at the consequences of those many disparate risks to their investment portfolio. Investors are advised to review their portfolios to make sure they do not have any outsized exposure to any of those potential risks.
Jonathan D. Caplan, a former Wall Street executive, is president and founder of wealth management firm Caplan Capital Management, Inc. with offices in Highland Park and Hackensack. He holds a BA from Yeshiva University and an MBA in finance from New York University Stern School of Business. You can find other recent investment articles by Jonathan at www.caplancapital.com/blog.
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