Jonathon Fite.

"The S&P 500 just formed a ‘Golden Cross,’ a bullish chart pattern with a solid track record.”

- CNBC Headline, July 10, 2020

As value investors, we focus on operating cash flows, balance sheet strength and management capabilities to drive improved performance. This column has often contrasted the fundamental, value-based approach to securities selection with other strategies like momentum styles and technical analysis.

We typically do not put much weight on “chart analysis” – the inspection of stock or index price movements to predict the future. But, they can be good indicators of market sentiment.

When sentiment is extremely bullish, we tend to get more cautious. Conversely, when market sentiment is extremely bearish, we tend to see that as a contrarian signal to start buying.

So, when CNBC broadcast the S&P 500 had formed a “Golden Cross”, we took notice. Sentiment was shifting from broadly negative to increasingly optimistic.

This happens when short-term trend lines cross over longer-term trend lines. For example, if you took a moving average of the last 50 days of S&P 500 index closing prices, and you compare that to the moving average of the last 200 days, you get a sense of market sentiment.

This pattern emerges when market downtrends bottom out as selling is depleted. The longer moving average is weighed down by the effects of that downturn. So, when the shorter-term trend line crosses above the longer-one, many traders see this as a confirmation of a new trend higher.

This has certainly been the case for many high-flying momentum stocks. Amazon breached the psychologically important $3,000 per share mark. Tesla surged above $1,750, and now has a market capitalization larger than Toyota, BMW, Ford and General Motors combined.

A closer inspection of the S&P500 index shows its performance is heavily concentrated in the 5 largest stocks (5 out of 500), and this concentration is the highest it has ever been – surpassing the levels last seen in the dot.com craze.

In 2000, the top 5 were Microsoft, GE, Cisco, Intel, and Walmart. Today the elite list still includes Microsoft, but also Apple, Amazon, Facebook and Alphabet, Google's parent company.

It seems incongruent that the market can be doing so well with so many people unemployed. But we are not living in normal times.

The pandemic has only modestly affected high-income earners – with employment rates ticking down from the high-90 to the low-to-mid 90% range. Low-income workers on the other hand have seen their jobs eviscerated, with employment rates falling from the high-90s to below 70%.

Even so, the combination of unemployment benefits and stimulus checks have actually increased disposable income for many of this group. With Netflix and Hulu content fully consumed, many retail investors have turned to day trading for their entertainment.

According to investment commentary from Grants, “day trading is even more contagious that COVID-19.” The newsletter writer outlines how brokerage firms across the US, India, China and the European Union all report surge in new account openings.

Many of these newly minted investors are plowing their stimulus checks into the highest-flying stocks. We have seen this movie before, and it does not end well.

Though, it could continue a while. U.S. House Speaker Pelosi signaled a willingness Monday to work with the White House to refine their next $3 trillion stimulus package. While it may get trimmed a bit, both parties are keen to extend government benefits that run out at the end of July.

What’s another trillion or two between friends?

While these funds will surely help voters this fall, perhaps bridging the span until a real COVID-19 therapy is available, one must wonder what side effects these stimuli might produce?

Could a generation or two who have never seen inflation, begin to feel its affects? Could the shock of not seeing bread or toilet paper on the shelf in March, only to see it return at twice the price in April, sew the seeds for an acceptance of meaningful inflation?

Coming out of the financial crisis, many pundits predicted a massive onslaught of 1970’s-style stagflation. But it never materialized.

Almost all the printed money from the Federal Reserve wound up buried in big bank balance sheets. This dramatically improved their capital ratios and safety, but coupled with no real fiscal stimulus, never resulted in the inflation so many expected.

Today, the Fed’s money printing is not being directed at the big banks. It is going directly into the economy by backstopping universal basic income checks and other forms of cash stimuli showing up in Joe American’s mail box.

This is creating actual demand while supply chains for oil, meat, and other agricultural products have been severely crushed. This is a recipe for much higher inflation.

Going back through the last 100 years, inflation doesn’t grow steadily – it’s more often like a switch that is flipped (see 1916-18, 1944-46, 1972-74).

If we have made the psychological shift from “that toilet paper is expensive” to “thank God, there’s toilet paper” – how quickly could the switch flip again?

Those who know their history know that most government programs don’t ever really go away. If we can follow one universal basic income check with another, or hear serious people talk about $10 trillion in reparation disbursements, how hard is it going to be to turn that funnel off?

The recent Fed monetization of government goodies may just be the start of a multi-year trend. Who knew Andrew Yang was so prescient?

Until then, earnings season is upon us. PepsiCo reported Monday they should be considered a “Stay Home” stock given our proclivity for munching on their salty snacks.

The big banks also report this week and should give a clue as to how bad rent-payment forbearance is winding through the real-estate sector.

By mid-August, the Q2 earnings reports will be in the rear-view mirror and the market will turn its full attention to the upcoming election, potential changes in tax policy, and the impacts of a hopeful COVID-19 vaccine on the 2021 economic outlook.

While the economy in the second-half of 2020 is sure to look better than it did the first half, the decline in employment may take a while to come back. This means volatility is likely to remain.

We remain pretty fully invested with a hard bias toward value. But, like the late-90s, a broad melt-up in tech and momentum stocks seems fully underway. Be careful out there.

 Jonathon Fite is a managing partner of KMF Investments, a Texas-based pure pay-for-performance hedge fund. Jonathon is also a professor with the G. Brint Ryan College of Business at the University of North Texas. This column is provided for general interest only and should not be construed as a solicitation or personal investment advice. Comments may be sent to email@KMFInvestments.com.

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