Research Report: State of Confusion

BY: Richard Croft
From our perspective there are two main factors influencing financial markets: 1) the seeming disconnect between market performance and economic reality and 2) the impact of the US Presidential election with potential constitutional challenges that go beyond who wins or loses. We will explore these issues in our commentary and share some of diversification techniques intended to protect client portfolios within the context of the long-term economic realities and the potential presidential outcome.



From our perspective there are two main factors influencing financial markets: 1) the seeming disconnect between market performance and economic reality and 2) the impact of the US Presidential election with potential constitutional challenges that go beyond who wins or loses.

We will explore these issues in our commentary and share some of diversification techniques intended to protect client portfolios within the context of the long-term economic realities and the potential presidential outcome.


Wondering why the trajectory of US equity markets seems to ignore the trajectory of daily new cases of Covid-19? Note the following images that chart the trajectory of the S&P 500 index and daily Covid-19 cases since March 24th, 2020.

With many southern US states being overrun by the virus, talk of shutdowns and rollbacks would seem to suggest a muted economic recovery. And yet stocks continue to rise! On the surface the price action seems counter intuitive. Dig a little deeper… not so much!

The following chart compares the performance of the S&P 500 index to the NASDAQ Internet ETF (symbol PNQI) whose top holdings include a basket of tech giants which represent 40% of the Nasdaq 100 index and 25% of the S&P 500 composite index. Note the outperformance of PNQI versus the S&P 500 composite index since March 24th.

What this tells us is that a few tech giants are underpinning this rally. More importantly, these companies (i.e. Amazon, Microsoft, Apple, Google, Facebook and Netflix) profit from stay-at-home consumers who shop, interact with other people and binge watch while social distancing. Which is to say, the fortunes of these companies are not tied to re-opening of the economy. These are high octane growth companies not value plays like financial institutions, brick and mortar retailers and the service sector (i.e. restaurants, airlines and entertainment venues) that require foot traffic to survive.

From this perspective, the stock market’s resilience may be reflecting a shift in consumer behavior not unbridled exuberance that has disconnected from economic reality. If the COVID-related exponential upswing in e-commerce continues at the expense of traditional retailers, we may be witnessing a watershed event that will drive markets for the foreseeable future. More importantly, it raises the prospect that swaths of the economy and the jobs that go with it, will never recover.

To understand the scope of how this shift in consumer behavior will impact markets in the future, it is important to recognize the scale of the problem. Think about the US $1 trillion plus names like Amazon, Apple, Microsoft and Google that represent 25% of the S&P 500 market cap. Tesla which is being considered as an addition to the S&P 500 index has eclipsed Toyota as the world’s biggest automaker.

These names and others in the tech sector, have generated billions in profits for investors and in some cases – i.e. Tesla – share prices have gone parabolic. All with little or no earnings. Nowhere can we find an example of a sector that defies what is happening on Main Street. The tech-laden Nasdaq is up 56% since its March low marginalizing the returns from the other sectors within the S&P 500.

Mainstream financials such as Bank of America, J P Morgan Chase and Citigroup are down sharply with limited prospects given the trend in interest rates. As we have been saying for some time, financials will be one of the last sectors to recover and will only do so when the economy normalizes.

As for the tech giants, it is difficult to see how they can continue their gravity defying ascension while the rest of the economy is suffering. At some point these companies become so large that they are the economy.

Take Apple as an example. It is a mass marketing success story. But with high end iPhones costing upwards of US $1,000 it is hard to see how mainstream consumers can part with that amount of money if they are lining up at the unemployment office and getting supplies from food banks.

Albeit within a different industry Google and Facebook face similar problems. These two companies control more than half the market for digital ads. They are the lifeblood for small companies with limited advertising budgets. If global economies remain comatose many of these smaller companies will not survive. At a minimum, Google and Facebook will have to consider charging less for digital ads just to keep their clients afloat.

Amazon and Tesla are outliers. Amazon is built for this type of environment and has been taking market share from online and store front competitors. Its’ cloud business is humming and when the pandemic ends, Amazon may stand alone with minimal competition.

Tesla is a mystery. It is a low-volume automaker that will at some point have to generate significant profits to justify its market cap. The question is when will investors transition from Tesla’s phantom growth story and demand to see profitability that can be used to apply some traditional growth metrics.

The bottom line is that Big Tech has benefitted from a stay-at-home boom and saved the broader markets from complete collapse. But how long can Tech giants stay away from the COVID-19 carnage that has beset the rest of the world. Our guess is not long!



We believe in the shift in consumer behavior and think this trend will last long after the pandemic ends. And while the behavioral shift has propelled big tech, the sector may have gotten ahead of itself. We will know more as we wind our way through second quarter earnings. Most importantly, our longer-term strategy will reflect guidance from the management of tech giants as to the earnings outlook into the third and fourth quarter.

That guidance should also provide insight into the trajectory of the general economy helping us fine tune sector allocations. For now, we will continue to employ a barbell strategy which holds a basket of growth companies (typically big tech names) complimented by dividend paying value stocks (i.e. financials, pipelines, utilities). The latter group remains in survival mode but with solid dividends that offer above average tax-advantaged yields, we are being paid to wait.


November 4th is election day in the US. Imagine the implications should one of the candidates win a narrow victory? What happened if Biden wins and Trump fails to accept the results because he feels cheated by fake mail-in ballots? Consider the turmoil if Republican-controlled legislatures in Michigan, Wisconsin, and Pennsylvania refuse to accept close election-night counts in their states. Could the Republican Party file lawsuits to prevent certification of the election results?

Under these scenarios, it is unlikely that the US Supreme Court will wade in preferring not to be the arbiter of another presidential election, as it did in 2000 following disputed vote results in Florida. Unless we witness massive street protests that convince the court to act. As justices ponder, government grinds to a halt. Armed militias prowl Washington.

Ian McGugan penned an interesting article in the Globe and Mail (Globe and Mail July 11, 2002) Report on Business that focused on just such a scenario.

We have reprinted much of his column as follows:

This ugly scenario was one of several explored in a recent “war games” organized by the Transition Integrity Project, a non-partisan group created by Rosa Brooks of Georgetown University Law Center and Nils Gilman of the Berggruen Institute, a Los Angeles-based think tank.”

The participants in the war games included Democratic and Republican political operatives, as well as constitutional lawyers and journalists. Each was assigned to play a role. Some represented the Biden campaign, others the Trump campaign. Still others took the places of elected officials, courts and other key players.

Their job was to explore how each of these key groups might plausibly act in four scenarios – a too-close-to-call outcome on election night, a Biden landslide, a narrow Biden victory, or a situation where Mr. Trump wins the Electoral College but loses the popular vote by an even wider margin than in 2016.

The disturbing conclusion? In three out of the four scenarios, the U.S. winds up in a political crisis. The only stable scenario is one where one of the candidates wins a victory strong enough to sweep away all doubts.

Investors may want to start praying for such a landslide outcome. A swift, indisputable victory by either side would provide at least one point of certainty in an economic environment full of unknowns.

Among the many questions for Canadian investors and companies is how Mr. Trump or Mr. Biden will address the huge deficits and high unemployment created by the pandemic.

Mr. Biden has indicated he would raise taxes on corporations and high earners, a move that might help reduce inequality. However, it could also hobble U.S. stocks. The immediate effect of the tax hikes would be to reduce 2021 earnings estimates for the S&P 500 by roughly US$20 a share, from US$170 to US$150, according to Goldman Sachs analysts.

More broadly, his plans would reverse more than half the US$2-trillion in corporate tax cuts pushed through by the Trump administration, according to an analysis by the Tax Foundation. But that doesn’t necessarily mean lower deficits. Mr. Biden’s economic advisers include Stephanie Kelton, a prominent advocate of Modern Monetary Theory, which argues debt and deficits matter less than many mainstream economists think.

In determining how to spuar a recovery, a Biden administration is likely to be just as nationalistic as the Trump administration. On Thursday, the presumptive Democratic nominee unveiled a proposal to spend US $700 billion on U.S.-made products and research. He also promised an end to loopholes that allow federal agencies and federal contractors to sidestep existing “Buy American” contracts.

At the very least, a Biden victory would squelch Alberta’s hopes for the beleaguered Keystone XL pipeline. The project, from Calgary-based TC Energy Corp., is designed to carry Alberta crude to U.S. refineries but has aroused opposition because of concerns it could worsen climate change. Mr. Biden has vowed to cancel the project’s permit if elected.

All of this suggests a Biden victory poses risks for Canada. On the other hand, a Trump victory creates threats of its own.

The President’s erratic trade policy frequently sideswiped Canada during his first term while his shambolic handling of the novel coronavirus crisis undermined confidence in the U.S. recovery. Even before the pandemic struck, his tax cuts had blasted a hole in the federal budget.

On the global stage, his increasingly tense confrontations with Beijing have helped to chill trade. Meanwhile, his disdain for international organizations has made it difficult for the West to form a united front on issues such as China’s increasing assertiveness, including its crackdown on dissent in Hong Kong.

For now, markets appear confident things will work out. Stock prices are rising even as prediction markets such as indicate the Democrats are poised to sweep the election. Mr. Biden is expected to take the presidency while his party is also forecast to win control of both the Senate and the House of Representatives.

The caveat is that nothing is for sure in 2020. Back in February, when the U.S. economy was booming, Mr. Trump’s re-election seemed like a done deal. Then the pandemic, a crashing economy and George Floyd’s death turned expectations upside down.

More drama may lie ahead. Multiple polls show Mr. Biden holds a impressive lead in the presidential race. However, surveys also indicate he stirs little passion among voters. A mere 6 per cent of respondents to a Pew Research Center poll in mid-June thought he would make a great president.

Mr. Biden’s strength lies in his middle-of-the-road, steady-as-she-goes persona. When going up against the divisive Mr. Trump, his reputation for personal decency may be all that is required to attract many centrist voters. But he is vulnerable if Republicans hammer him on the points where he is weakest – like how his son Hunter has managed to cash in on the family name with lucrative corporate gigs.

More than anything else, voters seem angry and volatile. The number of voters who describe themselves as “dissatisfied” has soared this year, according to another Pew survey.

The possibility of a close election in this charged environment raises some interesting scenarios. Among them is the risk the election result could remain in limbo until December or even longer.

The increasing use of mail-in ballots could contribute to such delays. In 2016, 24 per cent of ballots cast in the presidential election were via mail. The figure will probably spike higher this time around as voters seek to avoid ballot lines because of infection fears.

“In a close election, it will take time to count – and invariably re-count – all the mail-in ballots,” Goldman Sachs analysts headed by strategist David Kostin wrote in a report this week. A surge in absentee voting could leave the results of the election in dispute for weeks, the analysts say.

Any uncertainty would play into the hands of Mr. Trump. Many observers doubt he would leave office on Jan. 20 without exploring all options for contesting a close result. He has already laid the foundation for a possible challenge by making unsubstantiated claims that the increasing use of mail-in ballots will lead to voter fraud.

“Trump got himself impeached by trying to blackmail a foreign country into helping his re-election campaign,” Washington Post columnist Max Boot wrote this week after participating in the Transition Integrity war game. “He will stop at nothing to avoid the stigma of being branded a loser.”


As portfolio managers we constantly update strategies to effectively manage risk. We define risk as variance of return or volatility – how much is a portfolio expected to rise or fall as macro events unfold.

clipart photo generic red line graph

For example, in a perfectly diversified portfolio two securities would always move by the same amount in exactly the opposite direction. The portfolio would experience zero volatility.

Unfortunately, the investor will also experience zero return save for any possible dividends that might flow to the portfolio over time. Minimizing risk at the expense of performance is simply not a viable long-term strategy.

Investors do not perceive risk in terms of standard deviation. Investors’ risk aversion is tied to downside losses. Enter the concept of optimal diversification, which attempts to manage downside risk without impinging upside potential.

Optimization begins with macro decisions around the asset mix (i.e. percentage allocation to stocks, bonds, cash, and alternatives), geographic dispersion and ultimately, apportioning capital across sectors (financials, technology, energy, etc.) and investment styles (value, growth, momentum).

We augment those traditional metrics by using options to enhance cash flow and manage downside risk. This is particularly relevant in the current discussion because traditional diversification techniques cannot offset binary risks associated with post-election pandemonium or pandemic related shutdowns.

Option strategies can!

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Richard Croft, Chairman & CIO

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