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June 26, 2020
To the friends and clients of the Harvey Investment Company:
This is our third note to you since news of the new coronavirus became widely disseminated. Our first message, written on March 15th , reported the plunge in stock prices that ensued when it became clear that the virus would inflict serious damage to the economy. The second note, written April 23rd, indicated investors had begun to take the health crisis in stride. The stock market made a sharp recovery, though the S&P 500 was still down nearly 20% in the first quarter.
Today, June 24, finds the S&P 500 almost fully recovered---down modestly for the year. Other indicators, particularly those indexes heavily weighted with the favorite technology giants, are nicely ahead in 2020. We know from our contact with many of you, both in business conversations and in social settings, there is wide spread bewilderment at the robust stock market behavior in the face of genuinely horrible business conditions.
Viewed one way, there is nothing puzzling about the market’s imperviousness to the grim stream of financial reports. For decades, both the debt and equity markets have been tethered to the interest rate on long term US Treasury securities. When we say tethered, we mean that if the 20 year US Treasury bond rate was, say, 4%, that was the standard by which all other securities would be valued. Since US Treasury bonds were guaranteed by the US government, all non-guaranteed investments theoretically needed to be priced to produce a higher return.
Today, the 20 year US Treasury bond yields 1.3%, the 10 year note yields .77%, while US Treasury bills maturing in less than 2 years produce negligible returns. Using these interest rates as the standard by which to price stocks, historically extravagant valuations can be justified. In fact, as rates approach zero, the traditional modes of calculating the value of a common stock become non-sensical.
There are further considerations. Once, a wary investor could retire to the sidelines knowing he or she could expect a decent return, maybe 3% or 4%, while waiting for more inviting market conditions. That same investor gets paid nothing for his caution today. Why not just leave it in the market? Viewed this way, if business recovery from the coronavirus panic is slow coming, there is little cost to waiting it out. But it is not free. Annual return calculations are reduced if recovery periods stretch into the future.
Also, the role of the Federal Reserve Bank has morphed over the last fifty years. Its traditional mandate was to balance controlling inflation and promoting full employment. It managed its duties by regulating short-term interest rates----tightening money when inflation loomed and loosening when unemployment rose. Today, it has become the lender of last resort to prevent catastrophic financial conditions from leading to a depression.
Modern markets have become so interdependent that the Fed must even step in to bail out imprudent borrowers and lenders in times of panic. It also must accommodate the US government’s voracious fiscal needs----needs that have exploded as it tries to limit the damage from Covid-19. The Fed has arguably become the linchpin standing between the economy and disaster.
There is a last notable fillip supporting the stock market. In former days, the Fed purposely made its intentions obscure. It aimed its policy at the business community rather than investors. By keeping businesses from getting too comfy in their expectations, the attendant caution would temper the extreme booms and busts that had plagued the economy in earlier days.
Now the Fed goes to great lengths to telegraph its future actions. While this might induce the business community to be more confident in their planning, for investors it sends an “All Clear” signal. Currently, the Fed has virtually guaranteed no interest rate increases for at least two years. Most stock investors assume they can be confident that valuations will stay at historically elevated levels. For others, it is an invitation to rank speculation.
Events this year have solidified our view that the safest course for managing your assets is to be reactive instead of predictive. There is so little that one can know for sure. We’ll take this rising stock market any day over a plunging one like we had earlier this year. Nevertheless, in keeping with long- standing practice, we are likely to take a more cautious stance if prices reach higher and higher valuations. The current monetary conditions make for a very wide range of potential market developments in the months and years ahead. Expect anything.
On another note, accompanying this letter you will find a document taken from the ADV we file with the Securities and Exchange Commission, our chief regulator. We are required to send it to all our clients. It contains information regarding our services. We encourage you to read it and call us with any questions you may have.
We hope all is well with you, and that you have been healthy and happy in spite of the weird times we are experiencing. We have been working from the office continuously throughout the pandemic as we operate in a very safe work environment. But we miss the face to face contact with you as well as our travels to see company managements. Meeting personally with management teams is an important part of our research process. We’ll be happy when those meetings can resume in full.Thank you so much for your support. It gives our work special meaning.
Sincerely,Samuel C. Harvey