What the 'K Shaped' Economy Means for Your Financial Future

By Berna Barshay

Tuesday, September 29, 2020

► I’m familiar with the concept of economic recoveries that are shaped like letters…

I knew the characteristics that would designate an economic recovery a “V,” “U,” “W,” and even an “L”… But this fall, a new letter rose to prominence…

Welcome to the “K shaped” economy.

This is when professional workers in select industries bounce back quickly and experience the equivalent of the coveted, rapid “V shaped” recovery. Furloughed employees in industries like technology and financial services are called back, or are able to find new jobs to replace the ones they lost. Businesses that largely involve sitting in front of a computer or negotiating with other people on the phone or in person come back fast, albeit a little altered – sales meetings and business lunches go digital.

While the economic crisis may not financially affect these knowledge workers, low-wage, hourly employees experience something more “U shaped” (slow recovery) or even “L shaped” (no recovery).

Some people on the top half of the “K” are even left financially better off because of the crisis, as is the case for many workers possessing expertise in e-commerce, supply chains, and cloud software.

Employees at tech and e-commerce companies like Amazon (AMZN), Facebook (FB), Zoom Video Communications (ZM), Microsoft (MSFT), Walmart (WMT), Target (TGT), and Wayfair (W) live at the top half of the “K.”

Many restaurant workers, airline employees, hospitality industry shift workers, and other lower-paid hourly laborers live at the bottom half of the ‘K’…

Even though they’ve reopened, restaurants, airlines, theme parks, and hotels aren’t getting the volume of business they need to support their cost structures. You see layoffs looming at some big companies like airlines and an outright depression for many small businesses.

In a recent blog post about the K-shaped economy, U.S. Chamber of Commerce President Suzanne Clark explained that 94% of jobs lost in the financial-services sector have already been recovered, whereas leisure and entertainment industries have only hired back 74% of those laid off in the spring.

In fact, according to a Pew Research survey that came out late last week, only half of workers who got laid off during the pandemic are back at work. Given these trends, it’s no surprise that about 25% of respondents are having trouble paying their bills. A quick look at the survey shows that certain demographics, including low-income workers, are indeed having a much tougher time than others…

Source: Pew Research Center

 I saw the bottom half of the ‘K’ coming back in the spring…

In the May 8 Empire Financial Daily, I made the case that employment wouldn’t bounce back to pre-COVID-19 levels for a long time because of the slow recovery of hourly jobs tied to the restaurant industry and other hourly employee-heavy sectors (in which I believed the recovery would be more “U” than “V”)…

So many people I know are super-bullish, citing the unprecedented amount of monetary stimulus and the economy’s imminent reopening. But when I talk to my friends and professional contacts who work in brick-and-mortar businesses outside of finance and technology, their outlook is much more dour. Many employees are furloughed or laid off. Many small business owners are worried they will lose everything.

The bulls think the economy will reopen, that we’ll slowly get back to normal, and that all the jobs will come back.

This is highly unrealistic.

I was 100% right about these low-level jobs but 100% wrong about the effect this would have on the market’s direction. Between the unprecedented – and mind-blowingly massive – amount of monetary stimulus as well as the fiscal stimulus (enhanced unemployment benefits, stimulus checks, etc.), the market completely soared.

The market’s rise is itself another piece of the “K.” With interest rates so low, investors had no choice but to put their money into stocks, and low rates were themselves used as a justification for higher and higher valuations.

Low interest rates have also shored up residential real estate values, offsetting the pressure of higher unemployment levels. Low rates – which make mortgages more affordable and allow people to pay more for a house – in conjunction with a tight inventory stemming from new builds being interrupted last spring and people delaying moves until after the pandemic) led to listing prices rising over 10% year over year as of August, according to Realtor.com. In large metro areas, prices rose about 9%.

In the K-shaped economy, it’s not only good to be a professional desk jockey, but also an owner of financial and tangible assets.

Household wealth is soaring at the same time unemployment and food insecurity have exploded…

During the second quarter, after an initial dip, household net worth soared to take out pre-pandemic highs. As Bloomberg reported last week…

Household net worth increased by $7.6 trillion, or 6.8%, to $119 trillion, while the level of federal government borrowing soared as lawmakers responded with massive fiscal relief, according to a Federal Reserve report out Monday. The gain was the largest in quarterly records back to 1952. The value of equities advanced $5.7 trillion from the prior quarter while real estate increased about $458 billion.

With the S&P 500 Index up 20% in the second quarter, it was a great benefit to the 55% of households that own stocks (especially those that own a lot of them – a much smaller group), but the 45% that don’t own stocks saw no benefit from the market’s rise. This cohort without stocks overlaps significantly with the group of people working hourly jobs with low incomes, where employment is lagging.

Also left out of the asset boom are the one-third of households that don’t own a home.

A defining aspect of the K-shaped economy is that it has further widened the gap between the “haves” and the “have nots.” Earlier this month, in its discussion of the K-shaped economy, Fast Company noted that 84% of the stock market is owned by the wealthiest 10% of households. As the article elaborates…

Economic Policy Institute’s [senior economist Elise] Gould notes a flaw with the K model, in that it assumes that everyone started from the same place, when in fact there’s already been decades of societal disparity. The coronavirus didn’t create the K-shaped trend, only magnified it.

Yet again, we have a pre-existing trend pushed into overdrive by the pandemic.

Ultra-low interest rates prove to be a blessing and a curse…

While ultra-low rates have been a boon to equity holders, homeowners, and corporations who need to borrow money in general, low interest rates present a problem for retirees, people closing in on retirement, and anyone else trying to live on a fixed income. No matter how large your bond portfolio is, a 0% yield won’t pay the bills… and the Fed has signaled it will try to keep rates close to zero until 2023.

Rates near zero have turned the rules of retirement investing on their head and posed a challenge to the so-called “4% rule.” As Forbes explained last week…

Since it was conceived back in the 1990s, the safe withdrawal rate – at 4% per year – has become something of a gold standard of retirement planning. The basic theory is that a balanced portfolio, with a mix of both stocks and bonds, can be expected to produce returns sufficient to support a 4% annual withdrawal rate throughout retirement.

Because the overall return on the portfolio is expected to exceed 4% annually, the retiree would enjoy the income without fear of outliving his or her money.

When the 10-year U.S. Treasury yielded 3%, a 60% equity/40% fixed income portfolio would make 1.2% off its bonds. That meant that the stocks that made up the remaining 60% would need to contribute 2.8% of total return to get to that 4% goal, implying that stocks would need to rise 4.7% on average to hit the 4% return threshold for the whole portfolio.

Sub in a 10-year Treasury yielding only 0.7%, and the bar rises considerably for equity returns. With 40% parked in these Treasurys, that part of the portfolio would only return about 0.3%… leaving the 60% in equities to pick up the slack and contribute 3.7% to arrive at the magical 4%. Suddenly, stocks need to go up 6.2%.

Of course, this assumes a stable allocation of 60% stocks and 40% bonds. If the portfolio instead shifted to 75% stocks and 25% bonds, the required equity return on the stock portion of the portfolio would drop. In this way, ultra-low rates push retirees and other people living on fixed incomes into stocks.

With low rates, a fixed pool of capital, and a need for current income, the only way to solve the problem of bonds that don’t pay much is to get higher returns from the stocks you own… or redeploy cash out of bonds and into the riskier terrain of the stock market.

Getting the allocation right in a rate environment with few historical parallels is Challenge No. 1. Challenge No. 2 involves picking the right investments when one reallocates cash from bonds to stocks. A few months ago, of course, almost any stock would have been a winner. But going forward, stock picking could get harder… After all, we’re living in a K-shaped economy, with the obvious winners destined to continue winning, and the companies and workers stuck in the bottom part of the “K” facing unusually high uncertainty.

These are complicated times for financial planning, made no easier by such a bifurcated economy…

Fortunately, as an Empire Financial Daily reader, you’re already ahead of the vast majority of investors.

But if you want to be ahead of 99.9% of investors, I’d encourage you to sign up for our Empire Stock Investor newsletter.

Along with my colleagues Whitney Tilson and Enrique Abeyta, we’ve spent hundreds of hours over the past several months researching and performing our due diligence on a technological megatrend called “TaaS.”

It’s playing out all across the globe… And yet, most investors don’t know the best way to take advantage of it.

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In today’s mailbag, a reader tries to imagine how the criminals will cope with a truly cashless economy, and another notices insider sales at Peloton (PTON)…

Do you believe that we’re in a K-shaped economic recovery, or do you think that it’s shaped like a “V” or a “U”? Have you increased your allocation to equities because of the low absolute level of interest rates? Let me know… Send an e-mail to [email protected].

“In your September 23rd daily email you & Joe S were talking about how the shadow economy (which includes illegal drugs) will be forced into the light, so to speak, when we become a cashless society. I’ve been pondering something for quite some time… when/if we really do become a cashless society, how will people pay for their illegal drugs? We’re talking about many billions of dollars per year. Will they use crypto? Perhaps a privacy coin like Monero? Maybe. But I’m thinking a lot of users, especially those who are addicted to hardcore drugs like meth & crack, will ‘buy’ their drugs with stolen goods. What else would they do? I think it could set off a crime wave like we’ve never seen. Am I missing something? Would love to hear your thoughts.” – Greg F.

Berna comment: Interesting question, Greg. I think we’re probably a long way from a truly cashless society, but cash usage will nevertheless continue to decline over time. The last place it probably goes away is in illegal trade and under-the-table domestic work.

I’m not sure what criminals will use when we ultimately get there… it could be something modern like crypto, or they could go “old school” and use some combination of other rare assets, like gold, diamonds, guns, ammo, or other weapons. It’s hard to say… But looking at history, criminals are nothing if not creative.

“Why is there so much insider selling at Peloton?” – B.S.

Berna comment: I don’t think it’s that much insider selling for a stock that is up this much. I took a look at the largest insider sales… Two of the biggest came from institutions that owned privates shares in Peloton that converted into public ones – one was a venture capital (“VC”) fund and the other was the strategic venture capital arm of Comcast (CMCSA). Institutions that own private shares often have a mandate or policy to start taking profits after shares become public, so I don’t think these institutional sales raise any alarms.

The more meaningful transactions come from a company’s executives or board members. In this case, there were clearly some major sales… but of relatively small percentages of each selling insider’s total holdings.

Peloton President William Lynch did sell 783,576 shares, but this represents only 10% of his total holdings. CFO Jill Woodworth sold 300,000, but this was just under 9% of her holdings. Co-Founder and COO Thomas Cortese also sold 300,000 PTON shares. I couldn’t find his total holdings listed anywhere, so I can’t say what percentage of his holdings he sold… but I suspect that, as a co-founder, he has a lot more stock than just that.

With Peloton’s stock having tripled this year, I find it encouraging that the president and CFO – who have information that we don’t have – are still holding 90%-plus of their PTON shares.


Berna Barshay
September 29, 2020

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About Whitney Tilson

Prior to creating Empire Financial Research, Whitney Tilson founded and ran Kase Capital Management, which managed three value-oriented hedge funds and two mutual funds. Starting out of his bedroom with only $1 million, Tilson grew assets under management to nearly $200 million.

Tilson graduated magna cum laude from Harvard College with a bachelor’s degree in government in 1989. After college, he helped Wendy Kopp launch Teach for America and then spent two years as a consultant at the Boston Consulting Group. He earned his MBA from Harvard Business School in 1994, where he graduated in the top 5% of his class and was named a Baker Scholar.

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