Second Quarter 2020 Commentary: What a Short Strange Trip It’s Been

July 7, 2020

Mark Oelschlager, CFA

In 1976, Grateful Dead released “What a Long Strange Trip It’s Been.” The second quarter felt like a long strange trip, except it took place over just three months. We entered the quarter trying to flatten the curve, did so, and saw the economy reopen and social distancing restrictions relaxed to a degree. The market rallied, employment started to come back, the rate of new virus cases increased, and stocks sold off a bit as hopes for a quick eradication of Covid-19 faded. At the same time, the horrific killing of George Floyd in Minneapolis on Memorial Day and the resulting wave of protests and violence further shattered the spirit of the nation. While the virus and racial tension have been a double-punch to the country, stock prices for the most part have kept on “Truckin’.” After bouncing strongly late in the first quarter, they continued their ascent in Q2, shaking off several small sell-offs and a larger one in June to close the quarter up 20%. The Nasdaq rose more than 30%, hitting 10,000 for the first time. The market was buoyed not only by the leveling off in new virus cases but also the progress on managing those cases. Hospitals are learning what treatment strategies are effective and when to use them, and the death rate has consequently fallen. Covid-19 remains deadly for the elderly but far less risky than even the flu for children. Of course, children can pass it to their elders. These facts, along with the dramatic impact on the economy that the protective measures have had, have created intense disagreement among various groups about how to handle the crisis. Stock prices have largely been driven on a daily basis by the virus statistics, as investors know that a full economic rebound is dependent on a full reopening. In June, the number of new cases in the US leveled off at about 20,000 per day. But by the end of that month, they had hit almost 50,000 per day. One may have expected this to lead to a significant decline in stocks, and there was some volatility in June, but with deaths not having spiked (granted, there tends to be a lag between new cases and deaths), perhaps the market is starting to view this as a manageable problem. Time will tell whether this is appropriate or not. The employment data improved during the quarter. The number of jobs increased by 2.7 million in May and another 4.8 million in June, though the total remains 15 million below the February level. The unemployment rate fell to 11.1%, which is still very high. Stocks have also been supported by unprecedented monetary stimulus by the Federal Reserve. While the Fed should be commended for its fast response to the virus, and the targeted programs that it created in conjunction with the Treasury provided much-needed cash to companies and individuals who needed it, it may have gone too far. The credit markets returned to “normal” months ago, yet the Fed has continued to buy corporate debt. Chairman Powell says this is to provide liquidity and help keep the markets functioning, but the panic in financial markets has long since subsided and credit spreads have declined. Watching the Fed act as a participant in the corporate bond market is discomforting enough; but then to see which issuers’ debt they are buying – blue-chip companies whose debt is already in high demand - just adds to it. It is fair to ask whether the Fed’s definition of “functioning markets” really just means “keep prices high.” We are talking about bond prices, but stock prices benefit indirectly. We would like to see the Fed be more judicious in the use of its power, as the long-term consequences are unknown but potentially disastrous. Growth stocks have continued to be the darlings of the market. They have completed a triple crown of sorts by outperforming (for years) prior to the pandemic, declining less than the market during the correction, and beating the market in the rebound.[1] That is a rare feat. It is natural for people to want to gravitate toward stocks that behave this way, as they appear to offer an attractive upside AND the potential for capital preservation. Of course, all this outperformance has had an effect on growth stocks’ valuations, which have been pushed to high altitude. When you hear “growth stocks” you may think of the big ones, such as Google and Facebook, but the mega-cap growth companies are actually more reasonably priced than their smaller, lesser-known brethren. Empirical Research Partners tells us that the 75 companies with the best growth profiles (“big growers”), as an equally weighted group, currently trade at a relative (to the market) price/earnings ratio higher than anything seen over the last 68 years – higher even than in 1999, the peak of a growth-stock bubble.

As with all bubbles, this growth stock one has a compelling story behind it. The big growers have faster growth rates (of course) than the market, generally benefit from the digitization of the economy, have extraordinary profitability, and tend to be less impacted by the pandemic than are most companies. But even a great story can be carried to an extreme, and we believe that is what is happening now. High prices imbed high expectations. One reason their valuations are so elevated is that it is hard to see conditions changing. But we know conditions always do change – we just don’t know when. Meantime, it’s a game of chicken for the buyers of these stocks, with prices gradually ratcheting higher. It’s hard not to see the big growers underperforming from this starting point. Beware the “Dark Star.” We do own positions in a couple of the big growers that are trading at what we believe are reasonable valuations, but our current focus is on the other end of the growth-value spectrum, even more than usual. One reason that the growth stocks have such a high relative multiple right now is that much of the rest of the market is so cheaply priced. As we talked about in the first quarter commentary, valuations are much more widely distributed than normal, which means that a company’s valuation should be weighed even more heavily than usual when conducting an analysis. We don’t know when these wide spreads will come in, but we are confident that they eventually will, and when they do it will be the lower-valued stocks that benefit the most. Given the extreme valuation discrepancies in the market, it’s “High Time” the market’s leadership changed. Our focus remains not on what is hot now, but what will pay off over the long run. Best regards, Mark Oelschlager, CFA President and Chief Investment Officer Oelschlager Investments [1] Historical results are not an indication of future results. Investment Considerations: There can be no guarantee that any strategy (risk management or otherwise) will be successful. All investing involves risk, including potential loss of principal. Past Performance Does Not Guarantee Future Results. You cannot invest directly into an index. S&P 500 Index: Market capitalization weighted benchmark of 500 stocks selected by the Standard & Poor’s Index Committee, designed to represent the performance of the leading industries in the U.S. economy. Gross domestic product (GDP): The sum total of all goods and services produced across an economy. Standard deviation: A quantitative measure of deviation within a group. Valuationrefers to various measures that relate a financial characteristic of a company to the valuation accorded it by the market. Examples include price/earnings, price/book value, price/sales, and price/free cash flow. Price-to-earnings ratio (P/E ratio): The ratio for valuing a company that measures its current share price relative to its per-share earnings An investor should consider Towpath Focus Fund’s investment objectives, risks, charges and expenses carefully before investing. This and other important information about the investment company can be found in the Fund’s prospectus and summary prospectus. To obtain a prospectus or summary prospectus, call 877-593-8637. Please read the prospectus carefully before investing. Towpath Funds are distributed by Ultimus Fund Distributors, LLC (Member FINRA). Ultimus Fund Distributors, LLC and Towpath Funds are separate and unaffiliated.