An Uneasy Recalibration An Uneasy Recalibration 2020-3 (August)In March, as the COVID-19 crisis unfolded, many of us were looking – or perhaps more accurately, hoping – for a “V-shaped” recovery in both the economy and the financial markets. As we moved through April and May, our cautious optimism did not appear completely misplaced, but as always, it is critical as investors to differentiate between the economy and the markets.Real time data indicates that the economy, after initially rebounding as restricted states began to reopen and government support payments found their way into consumer spending, has at least temporarily flattened well below the prior level of economic activity. • Employment – people working, getting a paycheck – is logically crucial. Employment numbers did rebound aggressively off the catastrophic lows but have for now paused far below full recovery levels. Fortunately, government support has materially offset the lost income for many, with unemployment benefits replacing, and in some cases exceeding, prior income from employment. But the expanded unemployment benefit has expired, and its resumption remains politically uncertain as we write.• A significant resurgence in virus case numbers and hospitalizations from June into early August led to extended restrictions in some states and at least localized reinstatement of restrictions in others at a point in time when we had hoped economic activity would be heading toward some semblance of normality. As we move through mid-August, case numbers are clearly easing again, but with an uneasy equilibrium between ongoing control measures and the continued pace of infection.• Perhaps most significant, in the longer view, the breadth and scope of the resurgence have clearly had a material effect on elective consumer behavior, with increased personal caution evident in the tapering of traffic in businesses already most hard hit, even in areas that are otherwise “open”. This purely behavioral effect is far-reaching and may be currently underestimated in its ultimate consequences. Regardless of how any of us may feel about the way the numbers are selected and presented (it seems everyone apparently at this point either is an expert or knows an expert), there is without question a material effect on consumer confidence and thus consumer behavior to have a virus that is extraordinarily contagious and at least appears to be largely non-seasonal, asymptomatically transmitted, capable of remaining airborne for a considerable time, and can in some cases be very dam- aging or even lethal to you or someone dear to you.A vaccine has been widely considered the “silver bullet” that will return us to normal once developed and disseminated, but it seems increasingly evident that there will be material questions about the efficacy and the risks associated with vaccines being rushed through the normal development and testing process. As a consequence, they may be viewed with skepticism by a meaningful segment of the population, and that too is an economic problem, regardless of one’s personal opinion about any of the particulars.We will adjust – there is little doubt about that – but in some ways the route forward economically seems less clear than it did, prospectively, 3 or 4 months ago when we thought the virus was likely seasonal and that shutting down the economy for maybe 6 weeks or so could hopefully get it under control. Fortunately, we are learning at a rapid pace across multiple lines of scientific inquiry, with valuable and potentially ground-breaking insights emerging from very diverse areas of research, but the confirmation and correlation of strands of data takes time. As always, predictions abound, but there is little genuine clarity around the question of when we can expect things to be reasonably “normal” again.The equity markets, unlike the economy, have in broad terms more or less fully recovered, far outpacing the economic recovery. On the surface, this is normal and expected – markets look forward toward what is anticipated from the economy up the road. If there is a surprise in this instance, it is how far forward markets seem to be looking. While there are well-rea- soned differences of opinion among professionals about whether the market has gotten ahead of itself, there are legitimate factors underlying this rally, not all of them self-evident. With no intent of providing a comprehensive list, here are a few of them: • One is simple supply and demand; as a consequence of years of corporate share buybacks, among other things, there are far fewer shares of stock available now as compared to 25 years ago, and more investors seeking to buy.• With interest rates near historic lows, there are few alternatives for investors and institutions seeking – or desperately needing – meaningful returns on their capital.• Perhaps more obvious to the average investor, there is both a rational and psychological motivation to buy the expected “winners” in the economic transformation taking place – and, as in 1999-2000, the more their prices rise, the more some feel compelled to chase them. Valuations are by some measures becoming rather extreme – though not yet 1999 extreme, and unlike 1999, more of these companies have legitimate earnings and established business models. The conviction is that well selected companies, even if “overpriced” relative to current earnings, will with anticipated success grow into their valuations over time. Amazon is the now classic example of a stock that is always “overpriced”, selling at multiples way above the norm based on actual earnings, but has generated sometimes epic returns for those who continued to invest, leaving behind investors who kept waiting for a better valuation. (Simply bear in mind that even for an Amazon, price matters. Those who purchased anywhere within even 10% of the highs during the euphoria of mid to late 1999 saw the value of their investment drop close to 95% over the next two years, waited a decade merely to break even, and have never achieved what one could call spectacular returns even owning one of the dominant stocks of our era.)• At risk of getting a bit deep into economic theory, “when the Fed buys securities from non-bank entities, it directly boosts the money supply, and M2 has rocketed at an 83% annualized rate over the past 3 months” (Pantheon Macroeconomics, July 2020). As part of its efforts to stabilize credit markets, the Federal Reserve purchased hundreds of billions of dollars in Treasuries and mortgage-backed securities. Their stabilization efforts were successful, but between mid-March and mid-June, the Fed’s portfolio of securities held outright grew from $3.9 trillion to $6.1 trillion. This monumental surge in liquidity – cash looking for a home – has provided significant support to the equity rally.Reflecting on the latter point, one of the things we should consider as we all weigh our investment strategies is that government intervention in the economy and the markets on the scale we witnessed during and after the Financial Crisis of 2008-2009 – which has now been taken to another level entirely – fundamentally changes things, bringing a meaningful degree of uncertainty to many historically effective forecasting and analytical tools. Among the things one learns early on in this business is to beware the words “this time is different”, but a case can be made that this time actually is different, because the playing field has been changed – and in ways we may not begin to fully understand for many years.In May, we discussed the near impossibility of conducting meaningful economic analysis during the early stages of this crisis, but we suggested several keys to the path forward:The first key in the process of regaining some sense of clarity will be the pace of development of an appropriate combination of (a) induced immunity (from a vaccine), (b) natural immunity ( hopefully, from exposure and recovery), (c) scope of testing (critical for a virus which is transmitted asymptomatically) and/or (d) an effective remedy.A second key will be the pace of return of confidence and more normal economic behavior by consumers and companies.And another will be the extent to which production and consumption that is permanently reduced or destroyed in some industries is replaced by new production and consumption in new or expanded ventures. Disruption of this magnitude could launch a wave of creative development that could project us forward in ways far beyond what we can currently imagine. Despite the damage, one of the valid possibilities is that it could be the catalyst for a more productive economic future.As already illustrated, the first two have to date generated almost as many new questions as answers, but there are clearly “green shoots” from the third. The painful but often profoundly productive process of “creative destruction” is in motion. It is launching improved business models, enhanced efficiencies, creative new solutions and new areas of economic development. A world of opportunity awaits because of the awareness and thought processes this crisis has forced upon us. Change – particularly very painful, undesired change – can be a powerful creative stimulant. So, among the legitimate variables in this very complex equations the possibility that we could explode out of this crisis into a wave of economic progress unlike any we have seen in a couple of decades or more.Ultimately, as has been the case over much of the past 4 years, investors must choose between pursuing the real prospect of significant gains or maintaining a more balanced or conservative approach in recognition for the elevated uncertainty and down- side risk.The lure of the upside cannot be dismissed – within the complexity of this environment there is a very real potential for the market to move higher, perhaps significantly so. For investors who are aggressively inclined, there are opportunities worthy of consideration – so long as one remains cognizant of the significant market risks in play.For investors who are not aggressively inclined but need meaningful gains for personal financial reasons, including retirement, there is clearly a different kind of risk in play, the risk of missing important opportunities for growth. The very substantial market risks cannot be ignored – investment strategy for these investors should remain quite prudent – but it would seem unwise to sit on the sideline. “Challenging times” is clearly an understatement – but looking through it all, rays of sunshine, and considerable food for thought. Gordon T. Wegwart President, Chief Investment Officer This material contains forward looking statements; there is no guarantee these outcomes will be achieved. All investing involves risk of loss, and there is no guarantee that strategies which may have been successful in the past will be similarly successful in the future.