Author: subir

The 2023 Banking Crisis: A Wake-Up Call

The 2023 Banking Crisis: A Wake-Up Call

Dear friends,
The first quarter of 2023 was eventful, baffling and utterly predictable all at the same time. As with all manias, the bubble in crypto currencies finally burst last year and financial markets are seeing the repercussions. Unsurprisingly, the retrenchment in crypto currency prices exposed weaknesses and fraud. Crypto exchanges, service providers and investment funds have failed. Celebrities and others who promoted crypto-currency investments are being sued by investors who have suffered heavy losses. Regulators, who had previously seemed content to let crypto participants “innovate”, have suddenly discovered the virtues of regulation and enforcement, ostensibly their reason for existence.
The rot was deep enough to have impacted the ordinarily staid world of regional banking. Two regional banks associated with technology and crypto finance, Silicon Valley Bank and Signature Bank, found themselves the hapless targets of bank runs. The runs were a result of several factors: high risk lending practices, a large proportion of uninsured deposits relative to other banks, a balance sheet overexposed to long duration bonds and a savvy customer base that were quick to withdraw funds when rumors of potential failure spread. The FDIC placed both banks into receivership, and remarkably, extended deposit protection to all deposits, retroactively erasing the $250k limit on deposit insurance. This extreme step was taken to stem the flood of deposits fleeing regional banks, headed directly for accounts in banks believed to be Too Big To Fail.
The speed with which these banks failed was breathtaking and caught most depositors, investors, regulators and ratings agencies by surprise. On Wednesday March 8th, SVB announced it had sold $21 billion in long-dated bonds at a $1.8 billion loss to raise cash to meet depositor withdrawal requests. SVB also announced they would raise $1.75 billion in capital via common and preferred stock sales. By Friday March 10th, just two days later, the FDIC had taken over the bank and placed it into receivership. The stock never traded that day and was frozen at $106.04 per share, the price it had closed on Thursday. That day, the ratings agencies S&P and Moody’s, presumably blindsided by the collapse, promptly lowered their credit ratings for SVB from investment grade BBB and Baa1 to D and C (respectively). By Sunday March 12th, Signature Bank suffered the same fate as the FDIC placed the bank into receivership with the stock frozen at $70 per share. Moody’s and Fitch responded by lowering their ratings from Baa2 and BBB+ to D and C (respectively). In most cases, when a bank is at risk of failure, the market sniffs it out and there is time (weeks and in some cases months) for investors to position themselves appropriately. In this case, the failure was so swift the market and investors were largely unprepared (as evidenced by the levels the stocks were last trading at).
The banking crisis wasn’t limited to the US alone. Over in Europe, on March 19th one of the world’s most storied banks, Credit Suisse, was ignominiously sold to its chief competitor UBS in a weekend deal enforced by the Swiss government. This action broke all sorts of convention, shaking up the markets again.
Though we understand the reasons for some of the extraordinary steps undertaken by regulators and authorities, we do wonder whether some of this might not have been avoided. As anyone who has watched the classic “It’s a Wonderful Life” knows, no bank can survive a crisis of confidence. Once fleeing depositors reach a tipping point, a bank is no longer a going concern. Deposit insurance was designed to reduce the likelihood of runs and protect smaller
depositors who might lack information on the health of their bank and would be at a disadvantage to more sophisticated depositors. In SVB’s case, the bank’s business model had two Achilles heels. First, it relied on large depositors (tech startups and tech entrepreneurs), whose accounts were not covered fully by FDIC insurance. SVB also held a portfolio of long dated treasuries, which lost substantial value due to rising interest rates. Banks are allowed to carry loans and bonds at par on their books if they intend to hold them to maturity. Once the run started, SVB was forced to liquidate some of these bonds to meet withdrawal requests causing it to recognize the losses. This was the death knell, with the bank run accelerating as soon as SVB’s large depositors became aware of this dynamic.
On March 12th, in an effort to stabilize the banking system, the Fed took the unprecedented step of creating a new liquidity facility called the Bank Term Funding Program (BTFP) which allows banks to pledge longer dated treasuries for immediate liquidity at par. The hope is this facility should help prevent similar bank runs from occurring. In the subsequent weeks of this facility’s establishment, there have been no further failures in the US and the banking sector has shown signs of stabilizing. That said, while the cause of these bank failures is very different, we are reminded of the early days of the Great Financial Crisis when the prevailing wisdom was that the failure of a few smaller, over-leveraged financial institutions was an isolated incident that would not cause wider financial contagion. We’re not predicting a repeat of the 2008 cataclysms. However, ten years of zero interest rate policy has indulged a great deal of speculation in various markets, and we believe vigilance remains the prudent route.
Despite the current turmoil, markets have been remarkably resilient with both stocks and bonds posting positive returns for the first quarter. Large cap technology stocks, which took a beating last year, have rebounded and were the equity safe haven of choice for investors fleeing bank stocks in March. We’ve also seen both gold and silver perform well, which is to be expected when there is a crisis of confidence in the banking sector. Short term rates have crept higher as the Fed continues its ongoing battle to stop inflation before it becomes entrenched. This has created a great opportunity for cash investors as yields on short term CDs, treasury bills and money market funds approach, and in some cases eclipse, 5%. These are yields investors have not seen in over 15 years.
While 2022 saw a major correction in risk assets (with speculative assets taking the greatest hit), we don’t believe the asset bubble has fully deflated. We expect 2023 to be volatile as the Fed continues to grapple with inflation and maintain our preference for quality assets – highly rated bonds and equities with strong balance sheets in defensive sectors. With volatility comes oversold conditions and buying opportunities which we will look to take advantage of.
Please let us know if you’d like to discuss any of the above in more detail.
Best,
Louis and Subir

The foregoing contents reflect the opinions of Washington Square Capital Management and are subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or constructed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. 

Post performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.

2022: A Year of Turbulence for Investors

2022: A Year of Turbulence for Investors

Dear friends,
We hope you’ve had a chance to spend some time with friends and family over the holidays.
As we begin 2023, many investors are looking back at 2022 as a year they are more than happy to see come to a close. 2022 broke a multi-year streak of positive returns for equity markets with broad indices finishing in firmly negative territory. Speculative growth stocks were hit hardest as momentum investors reversed course and sold many high-flying tech and recent IPO companies. The S&P 500 finished the year down nearly 20% while the tech-heavy Nasdaq Composite was down almost 33%. International stocks didn’t fare much better as the MSCI World Ex-US Index was down nearly 17%. And the bond market, typically a safe haven during stock market selloffs, had one of its worst years on record as the Bloomberg Aggregate US Bond Index was down approximately 13%.
The immediate cause for this across-the-board drop is the trajectory of interest rates, as the world confronts inflation levels not seen in decades. US rates started 2022 at nearly zero and ended the year at 4.5%, a remarkable pace of increases in a very short time period. Several other central banks also raised rates in an effort to rein in inflationary pressures. Acting belatedly, but with determination, central banks have taken away the easy money punch bowl put in place in the aftermath of the Great Financial Crisis, ending one of the longest bull market rallies in history.
Last year, we wrote about the risk in speculative assets and how many were trading at unsustainable valuations, appearing vulnerable to a market correction. The rapid rise in interest rates created an environment ripe for mean-reversion as investors bailed on these assets almost as quickly as they had bid them up. The ARK Innovation ETF (ARKK), a much followed barometer for speculative growth stocks, was down nearly 67% in 2022. Cryptocurrencies, rocked by several high-profile scandals and bankruptcies (FTX, Block-Fi, Voyager and Celsius) also saw steep losses. The Bitwise 10 Crypto Index (BITW – a fund comprising the 10 largest cryptocurrencies) fell over 68%. SPACs (special purpose acquisition companies) – quasi IPO companies taken public via mergers that had become popular in recent years – were also clobbered. The AXS De-SPAC ETF (DSPC) was down over 73%.
So what did well in 2022? Despite the broad carnage, there were a few bright spots. Defensive sectors did ok, with healthcare and consumer staples down slightly, while utilities were up slightly. Rising energy prices boosted energy stocks and commodities, with both asset classes posting their strongest returns in years. Rising interest rates benefitted floating rate bonds, money markets, and cash. The USD, riding the wave of higher interest rates, was up nearly 8%, its best return since 2015. Gold and silver also held up well, posting slightly positive returns.
And while investors are hoping 2023 brings stability to markets, the last two weeks have reminded us that several non-economic factors have the potential to create further turmoil. The Chinese government suddenly reversed its policy on Covid isolation, leading to a sharp increase in the number of cases. This has placed stresses on the Chinese health care system that are similar to those experienced in the US in 2020 and 2021. It has also impacted several industries within China, where a large number of workers are absent. The re-opening of the Chinese economy will also likely put renewed pressure on commodity prices, which only in
recent months had started to fall. The recent US midterm election has left the House of Representatives in a very delicate balance. The possibility that a financial crisis might originate with action or inaction in the House of Representatives is distinctly higher than it was prior to this election (debt ceiling negotiations are already set to be a battleground). The political situation in several South American countries is quite tenuous, with Peru and Brazil in the headlines. Both countries are major producers of raw materials for industry and agriculture. The Ukraine war enters its second year without a clear path towards resolution. The potential for negative exogenous shocks to the global economy are higher than usual.
That has driven the World Bank to reduce its global growth forecast to below 2%, one of the lowest projections since the 1990’s. Most larger US-listed companies operate globally, and will be impacted by this slowdown in global growth. We have already begun to see businesses focus on cost reduction in a form that we haven’t seen for several years. While times were good and order books were brimming, weaker business models could limp along. We expect 2023 will be a year of reckoning for aging or obsolete product lines, with corresponding impacts on revenues and earnings, as well as an uptick in bankruptcy filings.
We expect the US Federal Reserve to continue its tight monetary policy through the middle of this year, albeit at a slower and more guarded pace. We expect rates to rise another 50-100 basis points, depending on inflation data. The impact of the past raises has not yet been felt by all enterprises, but it will reverberate through the entire economy over the coming year. Higher than expected rates will continue to place a drag on businesses for 2023, and we expect to see a visible impact on earnings, which have thus far been remarkably stable. This has the potential to lead to more selling of risk assets. That said, if we see inflation tamed and the Fed pause or reverse course on their interest rate policy, it’s likely markets will rally. It remains to be seen whether this rally would be short-lived or a sustained change of course for markets.
We continue to advise cautious allocations to risk assets as part of balanced portfolios. We have begun to see more reasonable valuations in certain sectors, notably technology. International and emerging market stocks with strong balance sheets are starting to look more compelling for long term investors, especially if we see weakening of the USD. After last year’s route, entry points for high quality bonds of short and intermediate duration look good. We believe gold and silver remain important components of a diversified portfolio in the current environment.
In general, though, froth and speculation remain in several sectors, and we aim to be selective in our investments, focusing on quality businesses that can weather an economic downturn and have long term potential for sustainable growth.
Let us know if you would like to discuss any of the above in more detail.
Best,
Louis and Subir

The foregoing contents reflect the opinions of Washington Square Capital Management and are subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or constructed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. 

Post performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.


How to Protect Your Portfolio in a Bear Market

How to Protect Your Portfolio in a Bear Market

Dear friends,
The 3rd quarter saw the US markets continue to be dogged by persistently high inflation with levels not seen since the early 1980’s. The underlying cause is partly lingering supply chain issues with a large contribution (over 60%) coming from energy and auto-related costs. Some of the supply chain issues (which began cropping up post-Covid lock downs) are now related to the on-going war in Ukraine. Dovish market observers and economists have vocally opposed the Fed’s aggressive interest rate policy response, claiming (not without merit) that the inflation figures are being driven by exceptional factors. Thus far, these arguments have not swayed the majority of voting members among the Fed board and 2022 has seen rates rise at a much steeper pace than the Fed themselves had projected just last year. The Fed has indicated a commitment to raising rates until they see inflation drop substantially from its current levels. Since unemployment remains at very low levels, there is little (barring a liquidity crisis) to stop the Fed from continuing on this path.
Elevated interest rates negatively impact credit-dependent businesses as well as stock/bond markets. They also impact public finances, since governments of all sizes have to pay more to borrow. Corporate borrowers also spend more on servicing debt, and marginally profitable projects get shelved when the cost of financing them rises. Consumers are also hurt as mortgages, auto loans and revolving credit lines become more costly, thus curtailing spending. All of this impacts corporate earnings, which will almost certainly drop from cyclical highs as the impact of rate rises is felt across industry.
In addition to inflation, we see several other signs to discourage aggressive risk taking. We have begun to see early indications of a drop in business activity. Certain US sectors such as real-estate, which are particularly credit dependent have slowed dramatically. US Job postings have dropped precipitously, though there continue to be far more job openings than in prior years. The IMF(International Monetary Fund) published a report indicating they now expect a global recession in 2023. The IMF’s Global Financial Stability Report indicates that the stability of global financial markets has “materially worsened” and markets face a higher likelihood of “disorderly pricing”. The US Treasury publishes an indicator of financial stress, which has been rising (albeit from very low levels) over the past few weeks. All of these indicators combine to raise risks for investors.
The lack of clarity around inflation as well as the potential for the Fed’s response to drive the economy toward recession has resulted in substantial selling in both stock and bond markets, with the bond market (through the first three quarters) posting one of its worst years on record. We expect to see continued volatility in both markets until investors see
definitive data suggesting a cooling of inflation and/or a pause/reversal of the Fed’s interest rate policy. If and when markets see a shift in policy, we expect stocks and bonds will rally sharply. However, there remains the risk that elevated inflation could become entrenched (which the Fed is aggressively fighting), in which case stocks and bonds would likely remain under pressure.
While market volatility can resemble a dizzying roller coaster ride, it often comes with opportunity. Bear markets can cause investors to act impulsively and sell assets indiscriminately in response to short term market conditions, without considering the long term. This leads to quality assets priced at discounted levels, levels much lower than an investor would typically find during a bull market. We continue to recommend a defensive allocation (due to the risks outlined above), but with an eye towards shifting money towards risk assets as prices fall further and entry points become compelling. Our long term outlook for the global economy remains positive and we expect patient investors will be rewarded.
Let us know if you’d like to discuss any of the above in more detail.
Best,
Louis and Subir

The foregoing contents reflect the opinions of Washington Square Capital Management and are subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or constructed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. 

Post performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.


The Impact of Inflation on the US Markets

The Impact of Inflation on the US Markets

Dear friends,
We hope you’re enjoying a pleasant summer with friends and family.
As we enter the third quarter of 2022, we are reminded of Lenin’s words on the Russian Revolution: “there are decades when nothing happens, and weeks when decades happen”. Events in the last three months have certainly fit into the latter category.
Earlier this year, the Russian invasion of Ukraine led to remarkable actions by financial and commercial institutions allied with the EU and US. As the war has dragged on, it is increasingly clear that the EU and US will not directly engage Russian forces, which reduces the immediate risk of this war drawing in many other actors. The tragic reality for Ukraine is that it is likely facing a loss of territory which will impact about half its population. The longer term lesson that all small/mid-sized countries will likely learn from this is that the only true deterrent for larger hostile nations is independent nuclear weapons capability. The treaty obligations made by Russia when Ukraine dissolved its nuclear weapons program in the 1990s aren’t worth the paper they were written on. The assurances made by the EU and US to Russia on the cusp of the breakup of the Soviet Union have been broken in both spirit and word.
In terms of impact to global markets, for now they appear primarily limited to the energy sector which has seen further supply issues. Equity investors exposed to Russia are directly impacted, but given Russia’s limited output and energy concentration, the short term direct impact remains minimal. Commodity prices have also been impacted, most notably oil/natural gas and wheat (Ukraine produces approximately 10% of the world’s wheat). This in turn has put additional short term pressure on inflation.
US financial markets have much broader issues to absorb and deal with. The weeks before the official start of summer saw every major US stock market index slip into bear market territory (defined as a 20% drawdown from the index highs). This was presaged by sharp, steep declines in the most speculative assets such as crypto-currencies and related tech. The onset of summer and a seasonal drop in trading has temporarily halted the declines, but the underlying causes have not disappeared and we suspect markets will continue to experience sharp volatility in the coming months.
We now have several months worth of inflation figures at levels we have not seen for decades. The Federal Reserve has telegraphed its intent to raise interest rates until inflation is under control. Their target rate for inflation is 2%, while inflation currently stands at approximately 9%. The risk of increasing rates too quickly is that it could drive the economy into recession. However, given where unemployment levels are (still historically low), it appears the Fed is more concerned with runaway inflation than recession risk. The thinking being they can always reverse course with rates once inflation is more manageable. Industries most sensitive to interest rates (mortgage origination and speculative new home construction among them) are experiencing sharp declines in revenue and canceled orders. In financial markets, speculators and corporate insiders who
have borrowed against stock, find themselves exposed as prices fall and the cost of carrying margin debt rises. This is a vicious circle that can lead to rounds of forced selling.
Since inflation concerns are driving the Fed’s aggressive policy moves, if inflation slows meaningfully, we could see the Fed pause to take stock. In this scenario, we would likely see both stocks and bonds rally (though this may be a shorter term relief rally). Intermediate and long term bonds are pointing towards such a pause in rate hikes. The closely watched 10-year treasury is back under 3% after nearly touching 3.5% in June. This suggests bond investors don’t expect interest rates to remain elevated long term.
This bear market comes at the end of a nearly 40 year long secular decline in interest rates and sustained low inflation. These trends were coincident with very large labor pools in Asia being integrated into the global economy. The deflationary impact of adding hundreds of millions of workers across Asia to the global industrial and services labor market seems to have run its course. Anecdotally, we are seeing salaries for remote service workers approaching rough global parity. This is likely to mean better conditions and more bargaining power for workers in the long run. In the short term though, the inflationary pressures will likely mean higher labor market volatility, including elevated unemployment. Similarly, an improvement in labor conditions and wages will lead to more sustainable and better quality corporate earnings. In the short term, it means increased market volatility.
Corporate earnings remain at cyclical and all-time highs for large capitalization stocks. Despite the recent declines, price/earnings ratios are not yet close to past cyclical lows. When we look around for signs of a bottom, they are scarce and distant. Our expectation is that the markets will remain volatile and further declines remain likely. We continue to advocate for defensive portfolios incorporating high quality stocks, short term/floating rate/inflation protected bonds, commodities and precious metals.
On the other side of this bear market lies another bull market and we will continue to keep an eye out for investment opportunities as they appear.
Best,
Louis and Subir

The foregoing contents reflect the opinions of Washington Square Capital Management and are subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or constructed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. 

Post performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.


The Global Economy in 2022: A Year of Turbulence and Uncertainty

The Global Economy in 2022: A Year of Turbulence and Uncertainty

Dear friends,
The first three months of 2022 have been very eventful in global affairs. The concerns surrounding the global spread of the Omicron variant have faded and been replaced with the surprising invasion of Ukraine by Russian forces followed by the unexpectedly robust retaliatory economic sanctions imposed by the US and EU. As with all such conflicts we hope it ends quickly with minimal further loss of life and suffering.
Russia’s invasion and the response it has engendered will likely have a long term impact on global finances. Within the span of days after the invasion, in a move that surprised many political pundits, Russian entities were shut out of the global payments systems. Credit cards issued on major networks stopped working and banks lost the ability to settle US dollar payments. The size and scope of the sanctions along with the widespread denunciation of the invasion (led by US and EU nations) seemed to have caught Russia off guard as prior Russian-led conflicts (Georgia, Donbas, Annexation of Crimea) had not been met with such unified opposition. Despite all this, EU markets continue to purchase Russian conventional energy, a position that appears increasingly farcical as other sanctions are strengthened.
In response to these measures, over the long run, we believe major economies outside North America and the EU will develop parallel financial systems to insulate themselves from any such punitive sanctions. The hand-wringing over the demise of the dollar as a global currency is probably exaggerated (that will likely not happen over the next two decades). But eventually we believe other currencies will play a larger role in global trade. This is to be expected and is a dynamic similar to the one that occurred over several decades when the British pound was replaced by the US Dollar as the primary means of international settlement in 1944. In the short term, there is no other major economy with a stable currency that can serve such a purpose since most aspirants (apart from the Euro) are either too small or have some form of capital control to limit currency fluctuation. The Swiss Franc has historically been a neutral alternative, but Swiss participation in the recent sanctions partly undercuts this role in the future. The Euro meets the size and stability criteria, but the Eurozone’s close alliance with the US is similarly likely to give other major countries pause when considering it as a backup. Physical gold has historically been a medium of last resort, but these sanctions have targeted Russian central bank gold reserve holdings as well as currency. This makes it less likely that non-allied countries will maintain large gold reserves in US/EU financial centers. It’s not unreasonable to say that blockchain concepts will play a role in any newly developed payment networks. We think it is unlikely that major central banks adopt one of the existing, independent crypto payment networks. They are far more likely to develop a new system/currency using the same technology as the early independent networks.
Both China and India have been moving towards developing independent payment networks for small and large transfers. We see this trend accelerating and the decades-long uncontested primacy of US/EU systems and networks will likely fade. This was, of course, bound to happen at some point as the locus of economic activity moves back towards Asia.
On the economic front, Q1 saw the US record inflation figures at levels not seen for decades. Some of this is due to a spike in energy prices and other dislocation in global supply chains. Regardless of cause, the hike in price levels likely spells trouble for both equities and bond markets. The Federal Reserve is poised to embark on a series of quick interest rate raises, coupled with a rapid reduction in its balance sheet. These moves would shift a virtually uninterrupted 16 years of easy money policies. The combination of inflationary pressure and rising rates are likely to have a larger impact on long-tenured instruments such as long-dated bonds and speculative growth stocks.
While the economic environment seems primed for rates to run higher, the Fed does have a recent history of pivoting on rate hike policy. 2019 saw the Fed reverse course after raising interest rates steadily over 2017 and 2018. The Fed made three rate cuts in 2019 (Trump’s trade war was referenced as a reason) and then slashed rates again to 0 in 2020 when the Covid-19 pandemic took hold. If inflation ebbs, the economy falters or demand slackens, we could see the Fed backtrack on their rate tightening plans.
While stocks and bonds have gotten off to a rough start in 2022, alternative assets such as commodities and precious metals have performed well. Value stocks in industries such as utilities and energy have shown positive returns on the year while speculative technology companies are deeply in the red. We continue to recommend a defensive, diversified
portfolio that is weighted towards value stocks over growth. With interest rates rising in anticipation of the moves from the Federal Reserve, we’re starting to see some compelling opportunities in the bond space. Tax free municipal bonds are starting to look interesting
again for the first time since the bond market upheaval in Q1 2020. While many speculative growth stocks have come down considerably in price, we still think there remains risk for further downside. We expect volatility to persist in 2022 and will continue to look for opportunities in stocks and bonds as they present themselves.
Best,
Louis and Subir

The foregoing contents reflect the opinions of Washington Square Capital Management and are subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or constructed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. 

Post performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.

The Dangers of Overvalued Technology Stocks

The Dangers of Overvalued Technology Stocks

Dear friends,
We hope you and your family have enjoyed a restful holiday season and a good start to 2022.
For investors, the new year comes with many continuing questions around trends in public health, government monetary policy and the rising cost of goods and services.
Perhaps weighing most heavily on investors’ minds is the recent surge in Covid Omicron cases. In the US, we are now seeing the highest number of weekly cases documented since the pandemic began. Globally, the US and EU appear to be the most heavily impacted in terms of case numbers. East Asian countries that have adopted immediate, effective lockdowns and mandatory isolation to reduce community spread are seeing smaller rises in new infections. Despite vaccines and various protective measures, this fast mutating virus remains with us and retains the capacity to cause widespread public health damage and economic disruption. Thus far, US markets have had a muted response to the new wave of infections, largely driven by the reluctance of state and federal governments to impose any form of lockdown to stall community spread.
The Covid crisis has, in many ways, made a lasting impact on the global investment landscape. Most white collar workers have now spent much of the past two years working from home. Technology usage in most businesses has accelerated, which has prompted investors to bid up prices for technology stocks to nose-bleed levels, with many trading at multiples of earnings not seen since the tech bubble of the late 1990s. There continues to be a long-term case for investing in technology stocks, but as with most investments, the levels at which you buy can often make the difference between profit and disappointment. At current levels, it is difficult to make a value driven case for most large, publicly-traded technology companies.
Tesla, in particular, is an extreme example. It is currently trading at a market cap that makes it more valuable than the 10 largest auto-makers combined. Those 10 automakers generate roughly 50 times the revenue that Tesla does, and each has an electric vehicle offering. Though Tesla has a devoted client-base willing to pay a premium for their product, it does not enjoy a meaningful technology edge, even in the premium car market, where German and Japanese car makers will offer stiff competition in the near future. Along similar lines, Zoom Communications offers a cautionary tale for speculative growth investors. When the effects of the pandemic were first being quantified, Zoom appeared unassailable and its stock price rose very quickly. In response, larger competitors strengthened their offerings, and as a result of this increased competition plus a decline in investor enthusiasm, Zoom is now 70% off its high from 2020. We’re starting to see similar trajectories for other high growth speculative tech names.
In general, equity multiples remain at elevated levels despite a remarkable surge in earnings during 2021. The broad S&P 500 index is trading at nearly 30 times the past 12 months earnings. The average multiple historically has been closer to 15. Corporate earnings are themselves at elevated levels, which implies even higher risk. If earnings and P/E ratios both revert towards the historic mean, prices would decline further and faster than if it were just one of these factors impacting markets.
In our view, it looks increasingly certain the Fed will follow through with its plan to raise interest rates this year. With unemployment under 4%, and the most recent CPI (inflation) reading for December registering at 7% –the fastest pace since June 1982– we see no conventional impediments to the Fed tightening rates. This of course means we will likely be entering a rising interest rate environment for the first time since late 2018. As a result, the support equity markets have enjoyed from rock-bottom interest rates will disappear. Investors holding long-dated bonds should expect some deterioration in the value of their holdings, as long-term rates generally rise alongside the short-term Federal Funds rate.
Underlining the anticipated rise in interest rates is the growth in debt issuance across the world. During the Covid pandemic, the US Federal government has added over 5 Trillion in debt. This is the sharpest rise in the past 30 years, though the trend has been steadily upwards. In 1990, US Federal debt stood at under 4 Trillion. 30 years later the US government has borrowed over 28.4 trillion. Debt as a percentage of GDP has risen during the pandemic as well, from 108% to over 120%. This is the highest it has ever been for the US. Other large economies have seen similar increases in debt levels during the pandemic, including China, the EU and India. Meanwhile, interest rates have remained below inflation in much of the world, minimizing the cost of servicing this debt. As rates adjust to more normal levels, public finances will need to be modified as well. In many countries this will lead to a search for revenues in the form of increased taxes. Higher tax rates would reduce corporate earnings, placing additional pressure on stocks.
We continue to recommend maintaining balanced portfolios, with a bias towards lower risk. Given the uncertainties we face and very high levels that equities are currently trading at, we advise investors to remain cautious and avoid the temptation to aggressively jump into what appears to be a very late-stage bull market. When bull markets break, they typically provide opportunities for investors to purchase high-quality companies at discounted prices.
With interest rates likely to continue rising this year, bond investors need to evaluate the maturities and duration in their bond portfolios. We recommend trimming longer term bond exposure and adding to shorter/floating rate bonds.
We expect 2022 will bring increased volatility in both the equity and bond markets. We think this volatility will also present compelling buying opportunities for investors in both markets.
Disclosure: Neither Subir nor Louis hold Tesla (TSLA) or Zoom (ZM) in their personal accounts. Tesla (TSLA) or Zoom (ZM) are not held in any discretionary portfolios at WSCM. Tesla (TSLA) is held in non-discretionary accounts at WSCM while Zoom (ZM) is not.
Best,
Louis and Subir

The foregoing contents reflect the opinions of Washington Square Capital Management and are subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or constructed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. 

Post performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.


Tech Sector Faces Headwinds as Interest Rates Rise

Tech Sector Faces Headwinds as Interest Rates Rise

Dear friends,
We hope you and your family have enjoyed a pleasant summer.
The third quarter began with risk assets continuing their relentless march upwards as US stock indices touched all time highs at the end of August. September, however, saw a bit of a reversal as the S&P 500 fell by approximately 5% on the month. Bonds also saw selling as the Bloomberg US Aggregate Bond Index dropped by approx 1% in September. A market where stocks and bonds sell off concurrently is a bit unusual (investors typically flock to the safety of bonds during times of stock selling), so what caused this to happen?
In our view, a shift in the Fed’s stimulus and interest rate policies are mainly responsible. The Fed has indicated they plan to begin raising rates next year and expect to taper their bond purchasing program later this year. Some market observers believe the Fed’s hand is being forced by recent inflation data, which appears to be more significant than transitory supply chain imbalances. If inflation continues to rise, the Fed’s accommodative policy response to the Covid-19 pandemic no longer seems prudent
(and may actually make things worse), warranting a change.
We believe these factors are primarily responsible for the recent volatility in stocks and bonds. The Fed’s bond buying program has provided ample liquidity, leading stock investors to rely on the Fed’s continuing support. In March 2020, the Fed’s announcement of a massive bond buying program signaled the market bottom. Conversely, if Fed liquidity goes away or is substantially reduced, stock investors would see it as a signal to reduce exposure to risk assets, hence the selling. Bond rates meanwhile have remained artificially low with the Fed’s 0% interest rate policy and monthly bond buying providing a constant bid for bonds. If the Fed’s bid goes away, then bond yields will revert to a market determined level which, given recent inflation data, could be considerably higher.
The threat of higher interest rates is also starting to drag on the technology sector, which has been the best performer coming out of the Covid-19 market correction. In recent years, Big Tech has become the juggernaut driving returns for the S&P 500. In fact, at the end of Q3, the top five companies by market cap were all tech names (Apple, Microsoft, Amazon, Google and Facebook) comprising nearly 25% of the index. This is an enormous number, illustrating how an index of 500 components has become top-heavy and concentrated. The last time the S&P 500 was anywhere close to this level of concentration was in 2000, at the height of the tech bubble, when the top five companies represented 18.2% of the index. You’d have to go back to the 1960’s, when the US economy was a very different animal, to find a number higher than 25%. While high concentration doesn’t necessarily portend a market correction, it can lead to a shift in investor sentiment. And the Fed’s change in interest rate policy may stoke that shift. Big Tech companies, like other growth stocks, are more sensitive to rising interest rates since their high multiples are based on the growth of future cash flows. When rates rise, the value of that cash flow is discounted. As a result, investors may lose their appetite to speculate on high multiple tech stocks and instead reallocate to value stocks which are trading at more reasonable valuations.
Shifting now to international markets, a story that made headlines in the third quarter was the emerging crisis in Chinese real estate. For the past 20 years, China has enjoyed tremendous growth in the construction and property sectors. Much of this is underpinned by real need as a large population migrated from rural areas to cities. But as is often the case during times of rising asset prices, the real growth has been supplemented by pure speculation. For years, we have observed these excesses without any real sense of whether they might come to a head. In the past month, two major Chinese real estate companies, Evergrande and Fantasia, have defaulted on debt obligations. The assumption among foreign investors has always been that the Chinese government would not allow such a critical sector to suffer widespread failure. That assumption is being tested. The response from China’s financial authorities so far appears to be to retreat behind the veil. The domestic listed securities of both companies have been suspended and there is no indication as to when they may resume trading. As China’s real estate sector has ballooned, various financial instruments have grown in its share to fund the enormous level of investment. A significant portion of this is held by households. All of which makes for an explosive situation, not dissimilar to classic bank runs. It remains to be seen whether this crisis spills over to China’s larger economy and impacts global markets, so we’re monitoring the situation closely.
As we head towards year end, we continue to maintain a cautious outlook and recommend moderate allocations to risk assets. While growth stocks look overvalued to us and could be at risk if we see interest rates continue to rise, we do see opportunities in value stocks. We think if inflation continues to run hot, commodities, inflation-protected bonds and precious metals will be prudent portfolio diversifiers. For long term investors, we think renewable energy stocks and emerging markets offer good risk/reward.
Please let us know if you’d like to discuss any of the above in more detail.
Best,
Louis and Subir

The foregoing contents reflect the opinions of Washington Square Capital Management and are subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or constructed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. 

Post performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.


The Stock Market is Bubbling: What Investors Need to Know

The Stock Market is Bubbling: What Investors Need to Know

Dear friends,
We trust you and your family have stayed healthy and are enjoying the summer thus far.
The second quarter saw major stock market indices maintain an almost uniformly upward trajectory. In our view, this expansion has been driven by three primary factors:
1. A recovery in business earnings
2. Accommodative fiscal policy
3. Expansionary monetary policy at the Federal Reserve
Earnings of large American companies have indeed rebounded over the past few months, almost retracing the steep 35% decline in earnings seen during 2020. Consumer and business spending have made up for lost time during the gradual reopening of the US economy. The future path of earnings though, is far from certain, as are the long term prospects for several companies, and even entire industries. This has not stopped investors from pouring money into the stock market at a record-shattering pace. According to data compiled by Bank of America, 2021 US equity inflows project to annualize at $1.178 trillion which would blow away not just any previous year, but the cumulative equity flows for the past 20 years ($777 billion). Other measures of equity market frothiness are also flashing major warning signs, including the amount of margin debt outstanding, which is at all time highs. These heady levels have not gone unnoticed by corporate issuers. IPO offerings are at record levels, with companies rushing to sell shares into a market eager to buy.
When viewed in historical context, current equity levels stand out as outliers on both valuation and technical levels. So it’s clear earnings and market dynamics alone are not telling the complete story.
The second major driver of equity froth is the enormous amount of government stimulus that’s been pumped into the system. US fiscal policy remains exceptionally accommodative as legislators rightfully express continued concern about the impact the pandemic has had on both consumer and business finances. Our expectation is that federal support for unemployment benefits and other support for consumers and businesses will continue at elevated levels, as will aid to local governments. Though not their primary purpose, these actions have in effect buoyed the equity markets, by putting a floor under household income and by extension business revenues in several sectors.
Monetary policy is the third pillar that has supported stock valuations. The Federal Reserve has made large dollar amounts available to the banking system. M1, the basic measure of money supply was expanded to include money market accounts in May 2020. This led to a vertical rise in the graph below, which we can ignore. However, M1’s growth has accelerated as the Fed has bought treasuries and other debt instruments with dollars, expanding its balance sheet and injecting those dollars into the system. You can see this in the slope of the graph below, beginning in March 2020 and continuing till today.

The Fed balance sheet now stands at over $8 Trillion, twice what it was less than 18 months ago. That means the Fed has injected $4 Trillion dollars into the US monetary system, a multiple of that when we consider the velocity with which money changes hands. Many of those dollars have found their way to the stock market as noted above.

The Federal Reserve has also continued to keep long-term interest rates at historic lows. Though unemployment rates have come down sharply from a record high, the Fed remains focused on improving the employment picture. We believe the Fed has recognized this pandemic is restructuring the US labor force in more fundamental ways, which has led it to be more cautious around raising rates. The civilian labor force participation rate has been on a downward trend as the baby boom generation ages out of the workforce, with many older workers retiring earlier than planned.

As workplaces have reopened, several million American workers have thus far remained out of the workforce, neither returning to old jobs, nor looking for new work. This is a secular shift in the US labor market, and will affect long term productivity and growth rates. These changes, along with other shifts, will impact other facets of the economy, including productivity. That said, there are some indications that the Fed is considering increasing rates in 2022, which is a year sooner than it had previously communicated.
The Fed has a dual mandate, to support full employment and control inflation. Housing costs are the largest component of the consumer price indices and the single largest expense for households. Single family home prices have been bolstered by low interest rates and an increased interest in such properties from financial investors. This has moved housing costs upwards for households buying homes over the past year. We have seen anecdotal reports of rents rising sharply in many parts of the country, particularly smaller cities that have seen an influx of telecommuters from coastal metropolitan areas. These anecdotal observations are borne out in the data, the housing price index trend line has recovered and become steeper in the past few months. Food prices have also begun to trend upwards. The primary gauge of inflation in the US is the consumer price index, which measures costs for a basket of goods and services used by an average US household. The CPI recorded its highest reading in 30 years earlier this summer, suggesting prices in May and June 2021 rose at an annualized 5% rate. If similar data continue to come in, we should expect the Fed will begin to raise rates sooner than anticipated.

If inflation were to rise suddenly, we would expect the bond market to react quickly. Long term rates would rise, and bond prices would move sharply lower. Bond investors have been remarkably sanguine in this era of historically low yields, lulled into complacency by very low levels of inflation. We have not seen long term rates over 5% since 2006, and inflation has remained below 5% for at least as long. If inflation expectations were to rise, bondholders would quickly face the prospect of negative real returns. In such a scenario, borrowing costs for businesses and governments would rise sharply, negatively impacting earnings. Our view is that the stock market will anticipate these events and sell off if it becomes clear that inflation is materially higher than it has been in the past 2 decades. Given the heady heights the stock market has attained, the sell off would be remarkable.
In our view, the Fed has been too lax in allowing such a bubble in risk assets to develop. By keeping rates at extraordinary low levels for over 15 years, and engaging in outsized asset purchases, the Fed has again allowed a dangerous situation to develop in asset markets, which could have an impact on the real economy. That said, the blame cannot be placed on the Fed’s shoulders alone. The US is an outlier among industrialized nations in having a very weak set of social service programs. Even these are not uniformly implemented, with many states further undercutting an already weak safety net. Over decades, several administrations and Congress have allowed these programs to atrophy. Instead of funding social programs, they have leaned on the Federal Reserve to maintain very loose policy. To put us back on a sound, sustainable footing, we will need to see the balance between fiscal and monetary policy restored in the US.
Looking ahead, we continue to advocate for cautious allocations in investment portfolios, with lower risk allocations than investors would take on in ordinary circumstances. There are strong indications that we are towards the end of a bull market for both equities and bonds. We view speculative growth/momentum stocks to be most at risk on the equity side and long duration and high yield bonds most at risk on the fixed income side. We continue to prefer value stocks over growth (despite value being out of favor in the current market) and view precious metals, commodities and inflation protected bonds as good diversifiers and hedges against potential inflation risk.
Best,
Louis and Subir

The foregoing contents reflect the opinions of Washington Square Capital Management and are subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or constructed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. 

Post performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.


The Pandemic’s Impact on the Global Economy

The Pandemic’s Impact on the Global Economy

Dear friends,
We hope this spring has brought you and your families a welcome respite from what was a hard, and isolating winter for many.
As we look forward to the course of this year, most observers are cautiously optimistic that the impact of the COVID-19 pandemic will steadily fade. As the pace of vaccinations has picked up in the US, so have expectations about an economic recovery. The impact of the additional stimulus bill passed by the new Congress has further driven optimism about the prospects for the US economy. Most equities analysts have chosen to write 2020 off as an outlier. Larger, public companies in many industries have managed to get through the past year largely unscathed, mainly due to the various fiscal and monetary measures put in place to aid them.
It appears as if the monetary stimulus in particular will remain in place for longer than some market observers view as necessary. Senior Federal Reserve officials have indicated the Fed has no plans to raise interest rates or amend its asset purchase program until 2024. This means bond investors can likely expect two+ years of stable, low short term rates. However, yields on intermediate and long term bonds have steadily crept up in 2021 driven by two factors: the recent sharp rise in commodity prices and the $1.9 trillion stimulus bill passed in March (with trillions potentially more on the way via an infrastructure bill). The rise in commodity prices signal higher inflation which some market participants think will cause the Fed to respond with an interest rate rise sooner than expected. The stimulus bill requires enormous amounts of treasury issuance to pay for it, and this influx of supply is causing longer term rates to rise. While this may end up being transitory and bond yields could settle back down, there is a chance that the Fed has not properly anticipated the possibility of a sharp rise in inflation and the glut of treasury supply may compound the issue for bond investors. Even with the recent rise on the mid/long end of the curve, bond yields remain low and we expect these lower yields and the possible risk of yields climbing higher from here to drive more bond investors into equities.
While equities may look attractive to bond investors smarting from rising yields, it has become an increasingly crowded trade. According to data compiled by Bank of America, more money has been invested in equity funds over the past five months than the previous 12 years combined. In dollar terms, that’s $569 billion flowing into global stock funds since November 2020 compared to $452 billion invested over the entirety of the 2009-2020 bull market. This kind of investment behavior is what markets tend to exhibit during manias as investors rush in to buy at any price. Though there are reasons to be optimistic about the potential for economic recovery, we believe the outlook for equities is far less certain. Equity investors today face prices that are at multi-decade highs, the prospect of higher corporate tax rates, an uncertain global vaccine rollout, and the possibility that a resurgence of the pandemic impacts critical sectors again.
The prevailing sentiment in the US is that the worst impact of the pandemic is behind us. That is not true for much of the rest of the world, however. COVID-19 cases continue to rise
in several countries and public health officials have responded by instituting closures to contain the spread. International travel remains uncommon and arduous in most parts of the world. The global economy continues to be susceptible to risks related to the pandemic. As stock markets globally are at or near all-time highs, equity risks are compounded by very high valuations. Historically low interest rates and the inflation outlook create similar conditions in bond markets.
With short and medium term market conditions so uncertain in both bond and stock markets, we advise investors to maintain defensive allocations. While risk assets may continue to rally on the back of continued easy monetary policies, valuations look stretched and risk/reward does not appear to be favorable. We still see some pockets of opportunity in value stocks, emerging markets and precious metals/commodities, but the pickings are increasingly slim. If sentiment shifts, we’d expect risk assets to pull back sharply, presenting better investment opportunities.
Best,
Louis and Subir
PS — We’ve moved! Our new office is located in the financial district: 222 Broadway, 19th Floor, New York, NY 10038. Attached is a notice about our address change, our annual privacy policy notice and our Q1 invoice.

The foregoing contents reflect the opinions of Washington Square Capital Management and are subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or constructed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. 

Post performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.


Sleeping Beauty’s castle

Sleeping Beauty’s castle

Dear Friends,

In the new year, we had hoped to put behind us the volatile political situation that has afflicted our country for the past several years. Unfortunately, the events of the past week have dashed those hopes. A violent attack on Congress has shaken many of our institutions. A few years ago, it would have been unfathomable to imagine an outgoing US president would encourage his supporters to march on the capitol. And this unimaginable thing too, has happened. We are struck this week, by the variety of friends and colleagues overseas who have expressed their incredulity and concern that such a thing might happen in the US. And yet it has.

The long-term vibrancy or malaise of every economy is underpinned by its legal institutions and politics. US institutions have been shaken this week, in a manner that will likely have long term implications. The world’s assessment of the US’s political stability and uniform application of rule of law have been dramatically undercut by remarkable images of a mob running amok through the US capitol. The near-term impact will likely be contained by the almost uniform condemnation of the actions that led up to the sacking of the Capitol buildings. Underscoring the seriousness, almost every business lobby immediately condemned the actions of the mob, and the politicians who incited them. This includes the staid National Association of Manufacturers.

As with virtually all the dramatic political events of the past few years, the market seems to have shrugged the past week off. Major US indices remain at or near all time highs, seemingly oblivious to the impact of the on-going public health crisis and the significant impact it has had on much of the global economy. Many long term investors see the vast disconnect between the underlying economy and the markets and wonder: how long can this last?

In the fairy tale Sleeping Beauty, an entire realm is enchanted and frozen in place when the princess falls asleep. The cook was arguing with one of his assistants before the enchantment and is about to strike him. When the princess awakens, the very first sound is that of the cook slapping his assistant.

In similar ways, the US economy and large swaths of the global economy have been frozen in time, seemingly enchanted by the actions taken by governments and central banks around the world to alleviate the public health impacts. The Federal Reserve has conjured its own spells all year, conducting large asset purchases and hinting at a long period of zero or near-zero interest rates. Stock market investors have participated wholeheartedly in this enchantment, driving many stocks well into bubble territory.

Just as in Sleeping Beauty’s realm, we expect we will all wake up one day, a day like any other, with a slap in the face and this historic bull market for stocks will come to an end. Given the heady heights this market has reached, the long road down is likely to be unforgivingly treacherous. We recommend equity investors maintain caution as the new year gets underway. We cannot say when exactly this bull-market will end, but several indicators, the amount of new issuance, the extreme euphoric rise of the past few months, underlying economic conditions and nosebleed valuations are all signals that have presaged the biggest changes in momentum during past market bubbles. Though much of the market is extremely overvalued, as usually happens at the tail end of a bull market, there are some attractive opportunities in stocks at the value end of the spectrum. The renewable energy/cleantech sector, after having a break-out year in 2020, still has some compelling opportunities for long term investors. We also view the long-term prospects of many emerging markets positively, and the valuations in these markets are not nearly as extreme.

For bond investors, this year has capped several years of very low yields, and an interest rate policy that is bent on driving investors towards riskier assets. We believe investors should continue to maintain allocations to high-quality short and medium term bonds, despite the limited return they offer. Exposure to speculative or longer-dated bonds should be reviewed for appropriateness, since these issues can be volatile when interest rates or perceptions of risk change.

Though we are not yet past all the public health dangers, we fully expect that this difficult period for our country and the world will come to an end soon, and we will finally turn the page on the difficult year we have had. During these challenging times, we wish you and your families health and peace of mind.

Please let us know if you’d like to discuss any of the above in more detail.

Regards,

Subir Grewal, CFA Louis Berger

The foregoing contents reflect the opinions of Washington Square Capital Management and are subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or constructed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. 

Post performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.

The Sleeping Beauty Market: Is the Bull Run Over?

The Sleeping Beauty Market: Is the Bull Run Over?

Dear friends,
As we reached the end of a year more tumultuous than most, we were reminded of the paramount importance of health. We trust you and your loved ones have remained healthy through the pandemic, and hope the new year will bring us all relief from the many challenges 2020 presented.
In the new year, we had hoped to put behind us the volatile political situation that has afflicted our country for the past several years. Unfortunately, the events of the past week have dashed those hopes. A violent attack on Congress has shaken many of our institutions. A few years ago, it would have been unfathomable to imagine an outgoing US president would encourage his supporters to march on the capitol. And this unimaginable thing too, has happened. We are struck this week, by the variety of friends and colleagues overseas who have expressed their incredulity and concern that such a thing might happen in the US. And yet it has.
The long-term vibrancy or malaise of every economy is underpinned by its legal institutions and politics. US institutions have been shaken this week, in a manner that will likely have long term implications. The world’s assessment of the US’s political stability and uniform application of rule of law have been dramatically undercut by remarkable images of a mob running amok through the US capitol. The near-term impact will likely be contained by the almost uniform condemnation of the actions that led up to the sacking of the Capitol buildings. Underscoring the seriousness, almost every business lobby immediately condemned the actions of the mob, and the politicians who incited them. This includes the staid National Association of Manufacturers.
As with virtually all the dramatic political events of the past few years, the market seems to have shrugged the past week off. Major US indices remain at or near all time highs, seemingly oblivious to the impact of the on-going public health crisis and the significant impact it has had on much of the global economy. Many long term investors see the vast disconnect between the underlying economy and the markets and wonder: how long can this last?
In the fairy tale Sleeping Beauty, an entire realm is enchanted and frozen in place when the princess falls asleep. The cook was arguing with one of his assistants before the enchantment and is about to strike him. When the princess awakens, the very first sound is that of the cook slapping his assistant.
In similar ways, the US economy and large swaths of the global economy have been frozen in time, seemingly enchanted by the actions taken by governments and central banks around the world to alleviate the public health impacts. The Federal Reserve has conjured its own spells all year, conducting large asset purchases and hinting at a long period of zero or near-zero interest rates. Stock market investors have participated wholeheartedly in this enchantment, driving many stocks well into bubble territory.
Just as in Sleeping Beauty’s realm, we expect we will all wake up one day, a day like any other, with a slap in the face and this historic bull market for stocks will come to an end. Given the heady heights this market has reached, the long road down is likely to be unforgivingly treacherous. We recommend equity investors maintain caution as the new year gets underway. We cannot say when exactly this bull-market will end, but several indicators, the amount of new issuance, the extreme euphoric rise of the past few months, underlying economic conditions and nosebleed valuations are all signals that have presaged the biggest changes in momentum during past market bubbles. Though much of the market is extremely overvalued, as usually happens at the tail end of a bull market, there are some attractive opportunities in stocks at the value end of the spectrum. The renewable energy/cleantech sector, after having a break-out year in 2020, still has some compelling opportunities for long term investors. We also view the long-term prospects of many emerging markets positively, and the valuations in these markets are not nearly as extreme.
For bond investors, this year has capped several years of very low yields, and an interest rate policy that is bent on driving investors towards riskier assets. We believe investors should continue to maintain allocations to high-quality short and medium term bonds, despite the limited return they offer. Exposure to speculative or longer-dated bonds should be reviewed for appropriateness, since these issues can be volatile when interest rates or perceptions of risk change.
Though we are not yet past all the public health dangers, we fully expect that this difficult period for our country and the world will come to an end soon, and we will finally turn the page on the difficult year we have had. During these challenging times, we wish you and your families health and peace of mind.
Please let us know if you’d like to discuss any of the above in more detail.
Regards,
Louis and Subir

The foregoing contents reflect the opinions of Washington Square Capital Management and are subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or constructed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. 

Post performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.


Two roads diverged in the woods.

Two roads diverged in the woods.

Dear Friends,

The third quarter saw bond and equity markets remain at opposite extremes in response to continued difficult economic conditions. Bond markets are signaling a long recession ahead, with interest rates projected to remain below 1% for the next several years. Equity markets, in sharp contrast, are priced near all time highs, despite a 20% drop in corporate profitability over the past two quarters, high unemployment and widespread business closures. 

So why the divergence? In our view, it’s the continued unprecedented levels of fiscal and monetary stimulus that has been pumped into the economy and markets (and the implied promise of more to come).  Excess liquidity has kept asset prices elevated and this is playing out in both the stock and bond markets.

Equity markets continue to hover around the highs reached in late summer after the remarkable rally from the bottom of the March lows despite economic activity remaining well below pre-pandemic levels.  The S&P 500 trades at 29 times trailing 12 month earnings and over 31 times normalized (10 year) earnings. These are peak levels, and unless there is an enormous rise in profits for companies of all stripes, these levels will be difficult to sustain.

Never has the adage that stocks trade on hope and bonds on fear rung more true. 

The third quarter also saw municipal and state finances partially recover from the free fall of the second quarter.  The impact on business sectors, however, has been highly variable. Residential construction appears to be a bright spot, presumably due to anecdotal reports that people working from home are investing in building comfortable working conditions. In contrast, commercial real-estate has not recovered to any material degree and many retail sectors, apart from consumer staples continue to struggle. Travel and leisure services are also hard hit, while technology products and services seem to be benefitting from the current work from home environment.

The Federal Reserve announced they would keep rates close to or at 0% at least until 2023, an indicator of how much medium and long-term damage the Fed believes has been done to the US economy by COVID-19. Low rates do help a recovery, at the cost of bond investors and ordinary savers. In our view, low interest rates alone will not be enough to help the economy recover; in fact, as evidenced by current stock valuations, low rates often encourage speculation, widen the already enormous wealth gap between the rich and the poor and create asset bubbles which can ultimately delay a cleansing of the economic system.  So in addition to an accommodative interest rate policy, we believe there needs to be a clear, effective strategy for the public health crisis that continues to hobble much of the country. The current administration appears to be banking on miracle cures which will resolve the crisis overnight. While there is a possibility that a vaccine will be available next year, and a smaller one that it will be over 70% effective, neither is assured. Meanwhile, the public health toll continues to mount on vulnerable Americans and industries.  

Though most other countries have managed this public health crisis better, global economic activity remains depressed and the world bank estimates global GDP will contract over 5% in 2020, a decline we have not seen in decades. In such an environment, with no imminent resolution to the public health crisis or its economic impacts, we continue to maintain a cautious allocation strategy, limiting exposure to risky assets.

We are now three weeks from a consequential presidential election in the US. A change in administrations is likely to bring about a reset in the US’s pandemic containment policies, with a stronger focus on preventive public health measures and clearer communication on the pandemic. If Congress and the government end up under Democratic control after November, we are likely to see another stimulus spending bill, tempered by broader restrictions to control the pandemic. If the current administration wins re-election, we would expect there to be a smaller stimulus bill, and a lengthier public health crisis. Neither of these events would have a material impact on the stock market. The bond market has the capacity to absorb large amounts of public debt, we do not expect increased debt issues to impact medium terrm rates while inflation is in check and the Fed keeps short-term rates low.
There is, however, a third possibility, that of a contested result and litigation over the presidential election. If this were to happen (as it did in 2000), we expect a lop-sided Supreme Court to side with the RRepublican candidate. This will have then been the second time in 20 years that the Supreme Court decided an election (against the winner of a popular majority). Such an outcome would result in lasting damage to the legitimacy of the court, and other public institutions in the country. This outcome is also the

We are now three weeks from a consequential presidential election in the US. A change in administrations is likely to bring about a reset in the US’s pandemic containment policies, with a stronger focus on preventive public health measures and clearer communication on the pandemic. If Congress and the government end up under Democratic control after November, we are likely to see another stimulus spending bill, tempered by broader restrictions to control the pandemic. If the current administration wins re-election, we would expect there to be a smaller stimulus bill, and a lengthier public health crisis. Neither of these events would have a material impact on the stock market. The bond market has the capacity to absorb large amounts of public debt, we do not expect increased debt issues to impact medium term rates while inflation is in check and the Fed keeps short-term rates low.

There is, however, a third possibility, that of a contested result and litigation over the presidential election. If this were to happen (as it did in 2000), we expect a lop-sided Supreme Court to side with the Republican candidate. This will have then been the second time in 20 years that the Supreme Court decided an election (against the winner of a popular majority). Such an outcome would result in lasting damage to the legitimacy of the court, and other public institutions in the country. This outcome is also the one most likely to be negative for investors in all asset classes. An uncertain outcome will hit US equity markets, and spook bond investors further.

Regards,

Subir Grewal, CFA Louis Berger

The foregoing contents reflect the opinions of Washington Square Capital Management and are subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or constructed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. 

Post performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.

The State of the Economy in 2020: A Cautious Outlook

The State of the Economy in 2020: A Cautious Outlook

Dear friends,
We hope you and your family are all well.
The third quarter saw bond and equity markets remain at opposite extremes in response to continued difficult economic conditions. Bond markets are signaling a long recession ahead, with interest rates projected to remain below 1% for the next several years. Equity markets, in sharp contrast, are priced near all time highs, despite a 20% drop in corporate profitability over the past two quarters, high unemployment and widespread business closures.
Why the divergence? In our view, it’s the continued unprecedented levels of fiscal and monetary stimulus that’s been pumped into the economy and markets (and the implied promise of more to come). Excess liquidity has kept asset prices elevated and this is playing out in both the stock and bond markets.
Equity markets continue to hover around the highs reached in late summer after the remarkable rally from the bottom of the March lows despite economic activity remaining well below pre-pandemic levels. The S&P 500 trades at 29 times trailing 12 month earnings and over 31 times normalized (10 year) earnings. These are peak levels, and unless there is an enormous rise in profits for companies of all stripes, these levels will be difficult to sustain.
The third quarter also saw municipal and state finances partially recover from the free fall of Q2, though cities and states hit hardest by the first COVID-19 wave are still looking at huge budget shortfalls. The impact on business sectors has been highly variable. Residential construction appears to be a bright spot, presumably due to anecdotal report that people working from home are investing in building comfortable working conditions. In contrast, commercial real-estate has not recovered to any material degree and many retail sectors, apart from consumer staples continue to struggle. Travel and leisure services are also hard hit, while technology products and services seem to be benefitting from the current work from home environment.
The Federal Reserve announced they plan to keep rates at or close to 0% at least until 2023, an indicator of how much medium and long-term damage the Fed believes has been done to the US economy by the COVID-19 pandemic. Low rates do help a recovery, but often at the expense of bond investors and ordinary savers. In our view, low interest rates alone will not be enough to help the economy recover; in fact, as evidenced by current stock valuations, low rates can often encourage speculation, widen the already enormous wealth gap between the rich and poor and create asset bubbles which can ultimately delay a cleansing of the economic system. So in addition to an accommodative interest rate policy, we believe there needs to be a clear, effective strategy for the public health crisis that continues to hobble much of the country. The current administration appears to be banking on miracle cures which will resolve the crisis overnight. While there is a possibility that a vaccine will be available next year, and a smaller one that it will be over 70%
effective, neither is assured. Meanwhile, the public health toll continues to mount on vulnerable Americans and industries.
Though most other countries have managed this public health crisis better, global economic activity remains depressed and the world bank estimates global GDP will contract over 5% in 2020, a decline we have not seen in decades. In such an environment, with no imminent resolution to the public health crisis or its economic impacts, we continue to maintain a cautious allocation strategy, limiting exposure to risky assets.
We are now less than three weeks from a consequential presidential election in the US. A change in administrations is likely to bring about a reset in the nation’s pandemic containment policies, with a stronger focus on preventive public health measures and clearer communication on the pandemic. If Congress and the federal government end up under Democratic control after November, we are likely to see another major stimulus spending bill, tempered by broader restrictions to control the pandemic. If the current administration wins re-election, we would expect there to be a smaller stimulus bill, and a lengthier public health crisis. We don’t believe the difference between these two outcomes will have a material short term impact on the stock market. The bond market has the capacity to absorb large amounts of public debt, we do not expect increased debt issues to impact medium term rates while inflation is in check and the Fed keeps short-term rates low.
There is, however, a third possibility, that of a contested result and litigation over the presidential election. If this were to happen (as it did in 2000), we expect a lop-sided Supreme Court to side with the Republican candidate. This will have then been the second time in 20 years that the Supreme Court decided an election (against the winner of a popular majority). Such an outcome would result in lasting damage to the legitimacy of the court, and other public institutions in the country. This outcome is also the one most likely to be negative for investors in all asset classes. An uncertain outcome will hit US equity markets, and spook bond investors further. It’s safe to say that investors (and Americans for that matter) would prefer a clear and definitive result on or shortly after election night.
Please let us know if you’d like to discuss any of the above in more detail.
Regards,
Louis and Subir

It was the best of times, it was the worst of times.

It was the best of times, it was the worst of times.

Friends,

The past several months have been a very challenging time bringing dramatic changes to all our working and personal lives. We hope you and your family are safe and in good health.

In the capital markets world, the past quarter has been nothing short of remarkable. In March, we saw the quickest descent into a bear market in S&P 500 history, driven by the extreme measures required to contain the spread of the Covid-19 pandemic. The S&P 500 hit a low of 2,237 for the year in late March. The 10Yr Treasury rate fell below 1% for the first time in its history. Since then, buoyed by trillions of dollars of stimulus support from governments and central banks around the world, many equity markets have recovered from those lows. The S&P 500 closed the second quarter at 3,100, only 10% below it’s all-time high reached in February. Most international equity markets have made similar recoveries as investors have shrugged off the economic fallout from COVID-19 with a view that any economic downturn will be short-lived and overcome by the flood of liquidity provided by central banks.

Bond markets are, in contrast, pointing to a far more pessimistic outlook. The 10 year treasury continues to trade below 0.70%, a level never reached before 2020. Buyers of 10 year Treasuries believe rates in the US will remain below 1% for most of the next 10 years. The 10 year rate for German bonds is -0.47%. That’s not a typo, it is a negative rate. Investors are paying the German government for the privilege of giving it money. Bond markets, which are larger and tend to be more restrained than equities markets, point to a deep and extended recession across much of the world.

Economic indicators seem to support the bond market’s view. In February 2020, over 152 million people in the US were employed in non-farm related activity. By May, that number had fallen to 130 million, as several industries largely shuttered their doors. June has seen some limited gains, with non-farm employment increasing to 138 million. The resurgence of Covid-19 cases in various parts of the country puts much of that partial recovery in employment at risk. And there’s concern that as the pandemic drags on many of these job losses may be permanent.

This pandemic has also stretched to the limit, the finances of many municipalities and states. Government entities generally maintain more stable levels of hiring and employment, but we have begun to see furloughs and layoffs in the government sector as well. 

The public health response in the US has been decidedly mixed. State governments across much of the North-East and Pacific coast appear to have acted on the advice of public health experts. In contrast, state governments across the south and south-east have been less careful, opening many public venues, beaches and businesses earlier than public health experts recommended. The unfortunate, predictable result is that the south and south-east of the country now have confirmed case rates that are as high as the north-east at its peak.

This pandemic has also exposed sharp differences in the response and capabilities of public health officials in different countries. When compared with the well-coordinated action taken in other countries, it seems clear to us that the US government has bungled its response to this pandemic. The rate of new infections has fallen sharply in much of Europe and several Asian countries like Japan, Taiwan, Vietnam and China. In contrast, the US, India and Brazil are reporting record numbers of new cases each day.  And unlike India and Brazil, the US is a developed nation that should have the organizational and healthcare infrastructure capacity in place to handle this type of crisis.

Back in February and March, there was a faint chance that a strong, coordinated global response might contain and then end the spread of the virus. The prior experience with SARS gave some hope. With confirmed global cases now at 13 million and rising sharply, it is clear that containment is not possible, unless far more draconian social isolation measures are implemented immediately across the world.  This scenario seems highly unlikely.  Our best hope now is that a vaccine or cure is found and the long-term health impact of contracting this virus is contained.

A great deal of uncertainty remains around the future trajectory of economic conditions and asset prices. A lot depends on the efficacy of potential vaccines and treatments for those sickened by the virus. The ability and capacity of businesses to adapt to changed circumstances is another key factor. Many businesses operating on thin margins have experienced enormous financial stress over the past few months. We have seen several high profile bankruptcy filings and expect to see many more before year-end. The response of consumers and workers to dramatically changed living and working conditions will play a large role in determining the level of economic activity in the months to come. Many households in the US and across the world have undergone severe financial strains over the past few months as several industries like hospitality, travel and entertainment have seen revenues dry up. When these workers return to their old jobs, or find new ones, we expect they will be more cautious about their consumption habits for quite some time.

Our view is that the US and economies around the world remain in the midst of a sharp global recession. The ineffective pandemic response in several large economies virtually guarantees that the impact of the pandemic will be with us through the rest of the year. As value investors looking at the level and direction of economic indicators, we see severe challenges for most businesses, a weak earnings environment and a significant drop in consumer demand.  While governments and central banks around the world have thrown trillions of dollars as a stopgap to address economic fallout, we don’t see this as a solution so long as the pandemic continues its current trajectory. That said, can asset prices continue to rise despite being completely untethered to the underlying economy? The answer is yes. The past few months have shown how flooding liquidity into the marketplace can boost stock prices. But rather than fixing the underlying problems in the economy, this liquidity is merely blowing up an asset bubble and stretching valuations to heights we haven’t seen since the dotcom bust in 2000. As any long term investor knows, the problem with asset bubbles is they eventually pop, often without any advance warning.

We recommend investors remain very cautious, and limit allocations to risk assets like equities.  We think investment grade bonds, inflation protected bonds, emerging market bonds and precious metals (gold and silver) are good alternatives in this environment.  We continue to believe there will be an opportunity to buy high quality risk assets at significant discount in the coming months.

Regards,

Subir Grewal, CFA, CFP Louis Berger

The Future of Investing in a Post-Pandemic World

The Future of Investing in a Post-Pandemic World

Dear friends,
The past several months have been a very challenging time bringing dramatic changes to all our working and personal lives. We hope you and your family are safe and in good health.
In the capital markets world, the past quarter has been nothing short of remarkable. In March, we saw the quickest descent into a bear market in S&P 500 history, driven by the extreme measures required to contain the spread of the Covid-19 pandemic. The S&P 500 hit a low of 2,237 for the year in late March. The 10Yr Treasury rate fell below 1% for the first time in its history. Since then, buoyed by trillions of dollars of stimulus support from governments and central banks around the world, many equity markets have recovered from those lows. The S&P 500 closed the second quarter at 3,100, only 10% below it’s all-time high reached in February. Most international equity markets have made similar recoveries as investors have shrugged off the economic fallout from COVID-19 with a view that any economic downturn will be short-lived and overcome by the flood of liquidity provided by central banks.
Bond markets are, in contrast, pointing to a far more pessimistic outlook. The 10 year treasury continues to trade below 0.70%, a level never reached before 2020. Buyers of 10 year Treasuries believe rates in the US will remain below 1% for most of the next 10 years. The 10 year rate for German bonds is -0.47%. That’s not a typo, it is a negative rate. Investors are paying the German government for the privilege of giving it money. Bond markets, which are larger and tend to be more restrained than equities markets, point to a deep and extended recession across much of the world.
Economic indicators seem to support the bond market’s view. In February 2020, over 152 million people in the US were employed in non-farm related activity. By May, that number had fallen to 130 million, as several industries largely shuttered their doors. June has seen some limited gains, with non-farm employment increasing to 138 million. The resurgence of Covid 19 cases in various parts of the country puts much of that partial recovery in employment at risk. And there’s concern as the pandemic drags on many of these job losses may be permanent.
This pandemic has also stretched to the limit, the finances of many municipalities and states. Government entities generally maintain more stable levels of hiring and employment, but we have begun to see furloughs and layoffs in the government sector as well.
The public health response in the US has been decidedly mixed. State governments across much of the North-East and Pacific coast appear to have acted on the advice of public health experts. In contrast, state governments across the south and south-east have been less careful, opening many public venues, beaches and businesses earlier than public health experts recommended. The unfortunate, predictable result is that the south and south-east of the country now have confirmed case rates that are as high as the north-east at its peak.
This pandemic has also exposed sharp differences in the response and capabilities of public health officials in different countries. When compared with the well-coordinated action taken in other countries, it seems clear to us that the US government has bungled its response to this pandemic. The rate of new infections has fallen sharply in much of Europe and several Asian countries like Japan, Taiwan, Vietnam and China. In contrast, the US, India and Brazil are
reporting record numbers of new cases each day. And unlike India and Brazil, the US is a developed nation that should have the organizational and healthcare infrastructure capacity in place to handle this type of crisis.
Back in February and March, there was a faint chance that a strong, coordinated global response might contain and then end the spread of the virus. The prior experience with SARS gave some hope. With confirmed global cases now at 13 million and rising sharply, it is clear that containment is not possible, unless far more draconian social isolation measures are implemented immediately across the world. This scenario seems highly unlikely. Our best hope now is that a vaccine or cure is found and the long-term health impact of contracting this virus is contained.
A great deal of uncertainty remains around the future trajectory of economic conditions and asset prices. A lot depends on the efficacy of potential vaccines and treatments for those sickened by the virus. The ability and capacity of businesses to adapt to changed circumstances is another key factor. Many businesses operating on thin margins have experienced enormous financial stress over the past few months. We have seen several high profile bankruptcy filings and expect to see many more before year-end. The response of consumers and workers to dramatically changed living and working conditions will play a large role in determining the level of economic activity in the months to come. Many households in the US and across the world have undergone severe financial strains over the past few months as several industries like hospitality, travel and entertainment have seen revenues dry up. When these workers return to their old jobs, or find new ones, we expect they will be more cautious about their consumption habits for quite some time.
Our view is that the US and economies around the world remain in the midst of a sharp global recession. The ineffective pandemic response in several large economies virtually guarantees that the impact of the pandemic will be with us through the rest of the year. As value investors
looking at the level and direction of economic indicators, we see severe challenges for most businesses, a weak earnings environment and a significant drop in consumer demand. While governments and central banks around the world have thrown trillions of dollars as a stopgap to address economic fallout, we don’t see this as a solution so long as the pandemic continues its current trajectory. That said, can asset prices continue to rise despite being completely untethered to the underlying economy? The answer is yes. The past few months have shown how flooding liquidity into the marketplace can boost stock prices. But rather than fixing the underlying problems in the economy, this liquidity is merely blowing up an asset bubble and stretching valuations to heights we haven’t seen since the dotcom bust in 2000. As any long term investor knows, the problem with asset bubbles is they eventually pop, often without any advance warning.
We recommend investors remain very cautious, and limit allocations to risk assets like equities. We think investment grade bonds, inflation protected bonds, emerging market bonds and precious metals (gold and silver) are good alternatives in this environment. We continue to believe there will be an opportunity to buy high quality risk assets at significant discount in the coming months.
Best,
Louis and Subir

The foregoing contents reflect the opinions of Washington Square Capital Management and are subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or constructed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. 

Post performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.