We all know that 9/11 changed everything, and so does COVID-19. Stay-At-Home orders, social distancing and masks are now familiar parts of our routine. Just as we evolved from 9/11, we will evolve from the novel coronavirus. Nevertheless, “Unprecedented” seems to be the word that best characterizes the first half of 2020. Listed below are relevant factors:
Although the broad stock market was down 3.1% for the first six months of 2020, Clorox was one of the top stock performers with a gain of 45%. Few people knew of Zoom at the beginning of the year, but it is up 6X from it’s April 2019 IPO. More obvious first-half winners include Amazon up 49%, NetFlix up 41% and Apple up 25%. On the speculative side, Tesla was up 158%. Airlines were the obvious losers with Delta down 52%
Index Benchmark Performance As Of 6/30/2020:
|Major Benchmark Performance:||Last 3||Last 12|
|US Large Cap-S&P 500||1.99%||20.54%||-3.08%||7.52%|
|US Small Cap-Russell 2000||3.53%||25.42%||-12.98%||-6.63%|
|Foreign Developed-MSCI EAFE||3.40%||14.87%||-11.36%||-5.15%|
|Foreign Emerging Mkts-MSCI EEM||7.35%||18.09%||-9.77%||-3.38%|
|US Bonds-Barclays Aggregate||0.63%||2.90%||6.14%||8.74%|
|Long Treasury-20 Yr+ US Treasury Bonds||0.13%||0.12%||21.62%||25.97%|
The Bear Market struck with a vengeance in March after a record long 11-year bull market and a record long 10 ½ year economic expansion:
In addition, the drop was accompanied by record-high volatility. The S&P 500 fell from an all-time high to a bear market decline of over -20% in only 22 trading days, the quickest decline in history, even faster than during the Great Depression. Moreover, the S&P 500 set a record of eight consecutive days in which the index moved up or down by at least 4%. Then, the S&P 500 made the quickest recovery in history from a Bear Market to a technical Bull Market (up 20% from a recent low). With the price volatility at record levels in both directions, the overall investment performance has improved significantly since the March 23 lows.
Performance has rebounded since the March lows:
Although the S&P 500 fell -33.9% by March 23 from the all-time high, it is now down only -3.1% YTD as of June 30. The first quarter had the worst performance since the 2008 Great Financial Crisis, and then the second quarter was the best performance since the 4th quarter of 1998. This whiplash was the first time with such extreme quarterly performance since the 1930s. U.S. small caps continue to lag behind the perceived relative safety of larger U.S. companies and are down -13% so far in 2020. Foreign developed equity is down -11.4%. Emerging markets were the big surprise during June with a gain of 7.4%. Longer maturity U.S. Treasury bonds benefited from declining interest rates and from investors seeking a safe haven, and are up 21.6% so far this year. Corporate bonds and especially high yield declined sharply in March due to increasing recessionary fears, but have since recovered somewhat in April through June largely due to the Federal Reserve’s corporate credit support.
Some market prognosticators refer to the big Q2 price recovery as the “Hopium” Trade and the Silly Season, but the reality is that the short-term market is difficult to predict and it forces humility on us all.
Economic Statistics are coming in better than expected:
Although economic statistics initially dropped precipitously due to the government-induced shutdown, they are now showing a significant improvement.
–Unemployment (at a 50-year low of 3.5% in February) spiked to 14.7% in April but has since dropped to 11.1% for June. Although this unemployment level is still a high level, it reflects the addition of 4.8 million new jobs and it was much better than the market expected.
– The Conference Board reported that its Consumer Confidence Index rose to a reading of 98.1 for June from 85.9 in May. Economists polled by Reuters had forecast the index rising to only 91.8 for June.
–Retail sales for April declined 14.7%, the largest decline since 1992 when this data series was initiated. However, May retail sales jumped a record 17.7% on a month-over-month basis, well above the consensus expectation of 7.5%. Retail sales were impacted by pent-up demand and government checks, so it is difficult to know what retail sales level will be reported in the future. It is important to note that the May sales report was still down -6.1% on a year over year basis.
-The Leading Economic Indicators came in at a positive 2.8% after falling -6.1% in April and -7.5% in March. These statistics point to the sudden, large shutdown of the U.S. economy caused by the unprecedented coronavirus pandemic, and then an encouraging uptick.
Progress on Vaccines and Treatments:
Vaccines and treatments hold the promise of allowing the global economy to get back closer to normal, and there are numerous reports showing progress. The U.K. government approved the use of dexamethasone, a steroid that cuts the risk of death for patients on ventilators and for those on oxygen. There is also preliminary evidence supporting Gilead Science’s Remdesivir, an anti-viral treatment, and by vaccines from Moderna, Pfizer and others. Moderna was said to “show promise” in phase-one trials and is progressing to phase-two trials. Dr. Anthony Faucci, Director of the National Institute of Allergy and Infectious Diseases, also expressed optimism regarding a relatively quick approval. However, a 12-18 month timeline still looks more likely. Any COVID-19 vaccine would likely be first used to protect front-line health care workers and elderly who are at most risk to the virus. Over time, a vaccine would achieve “herd immunity”, whereby the antibodies of the majority of individuals built up, either via exposure or vaccination, are sufficient to protect the remaining vulnerable people. In the short-term, however, there is clearly a risk of a “Second Wave.” Broad-based testing needs to be expanded so virus carriers can be identified and isolated.
FOMO-the Fear Of Missing Out:
The recent market strength has surprised many institutional investors, and there does appear to be an element of FOMO-the Fear Of Missing Out. Markets trade on fear and greed, and the current market strength appears to have a significant amount of momentum-based trading. Retail trading is up sharply based on commission-free trades and accounts like Robinhood that are said to be having significant trading volumes based on inexperienced traders.
As states move to reopen, there has been an unfortunate surge in new coronavirus cases and rising hospitalization rates in states like California, Texas, Florida and Arizona. This has once again overstretched the health care system, and especially ICU units. As a result, a number of states have paused or rolled back their re-openings, especially related to bars and restaurants. There is also the prospect of a mutated version of the virus flaring up in the fall and winter. Consequently, COVID-19 remains a global wildcard.
Market Valuations remain rich:
At this point, markets are ignoring weak 2020 corporate earnings, and are trading on expected 2021 earnings. Nevertheless, various valuation metrics (like Price/Earnings ratios) for 2021 are still elevated. It is important to remember that valuation doesn’t predict short-term performance, but valuation definitely impacts long-term performance potential. In other words, markets could continue to move up on a short-term basis, but the longer-term performance might be a 5-7% average return/year rather than the historic 10%/year long-term U.S. stock return average. See Market Valuation
According to recent political polls, Vice President Biden is leading President Trump by a significant margin, and the U.S. Senate might shift to control by the Democrats. In the case where the Democrats win the presidency and control both the House and the Senate, then tax increases are likely. Joe Biden has said he would raise the corporate tax rate from 21% to 28%, rolling back Trump’s 2017 corporate tax reforms. Greater restrictions on corporate share buybacks are also likely. A report from Goldman Sachs estimates that such an outcome would shift 2021 earnings per share for the S&P 500 to $150 from a current estimate of $170. It is probably safe to say that a large earnings decline caused by a corporate tax increase would negatively impact market performance. For individuals, higher capital gains tax rates, the elimination of the qualified dividend tax rate, and/or higher tax rates on top income earners are expected. Without getting too deep into tax policy, there is a strong argument that higher corporate taxes makes our U.S. companies less competitive in international markets. To the extent that U.S. companies are less competitive in the international market place, then they don’t expand U.S. operations and they don’t hire U.S. workers.
Stock Market and Economic Disconnect:
The markets were buoyed in the second quarter by progress in “a flattening of the curve”, the prospect of re-opening the economy, and early reports regarding treatments and vaccines. Moreover, recent economic statistics show a stronger-than-expected rebound from the initial dramatic declines. As a result, the market seems to be anticipating a V-shaped recovery. Although a downdraft to the March lows does not appear likely, there are numerous risks that could cause market weakness.
While recent economic statistics have been stronger than expected, they may reflect more pent-up demand rather than long-term growth. Economic growth over the next year faces significant headwinds and is not likely to quickly recover lost output. The economic recovery still looks like a “Nike Swoosh” or even a U-shaped recovery, not V-shaped, and it looks like there is a disconnect between the recent market rebound and the broader economic landscape. Although the market was up in the second quarter, it still looks vulnerable to additional sell-offs. The current situation seems to be the opposite of what happened in December 2018. At that time, the market sold off hard based on fears of a global economic recession, even though the economic data did not show an imminent recession. In January, 2019, Cornerstone described a Market/Economic Disconnect where economic fundamentals in late 2018 were much stronger than indicated by the sharp market decline. This time, however, the economic fundamentals are very weak, but the market has been ignoring these weak fundamentals as it rebounded significantly in April through June. Only time will tell how the coronavirus recession plays out, but it is helpful to stay grounded in longer-term economic and market fundamentals.
It is helpful to remember that Bear Markets since 1950:
-the average bear market declined -35% and lasted an average of 14 months.
-the average bull market gained 199% and lasted an average of nearly 6 years.
Bear markets are typically much shorter than bull markets, they go down less, and they have always given way to another bull market.
The Federal Reserve has been very proactive:
ensuring funding for banks and companies. The Fed re-established many of the initiatives from the 2008 Great Financial Crisis that have proven positive in the past. A major difference is that the Fed established these support programs so quickly. The Fed cut the Fed Funds rate to near zero in an emergency meeting.
The Fed also provided a “do whatever it takes” stance to support lending for small and large businesses, money market funds, state and local governments, and global central banks for foreign investors seeking the safety of the U.S. dollar.
U.S. Fiscal Legislation:
Congress passed a $2.2 Trillion coronavirus aid package to help stabilize the U.S. economy. Key provisions include support for individuals (the Paycheck Protection Plan and increased unemployment benefits), small businesses, large corporations, public health, and state and local governments. This package is being called a rescue plan, and many politicians say there will need to be another round to provide stimulus. As with the Federal Reserve’s timely actions, the legislation is being implemented far faster than was the case in the 2008/2009 Great Recession.
U.S. Federal Budget Deficit:
Morgan Stanley released an estimate of the U.S. budget deficit of $3.7 Trillion for calendar year 2020, and they see an additional $3T in 2021. This would make the deficit approximately 15-20% of the U.S. GDP. This is larger than the 2008/2009 Great Recession level. This analysis does not incorporate the proposed $2T infrastructure bill. Although there is a clear need for monetary and fiscal spending during this downturn, there is also a looming longer-term issue related to U.S. budget deficits.
China was the first country to lockdown its economy in January, and official data show positive economic manufacturing and non-manufacturing growth resuming in March. These reports do not indicate an imminent global turnaround, but they do represent a measure of improvement in China. The Eurozone is experiencing economic improvement from the lows of March and April, but they are mired in an economic recession. Japan is also stuck in a deep recession.
On a global basis, a June International Monetary Fund forecast shows a -4.9% 2020 global economic decline and then a 5.4% recovery for 2021.
There is no good historic precedent for the coronavirus given that globalization has allowed pandemics to spread much more quickly than in the past. Consequently, we are in the midst of a global recession. The first quarter market downdraft caused a lot of economic weakness to be priced in, but the strong second quarter market performance has now priced in a fairly optimistic outlook. Since the depth and duration of the coronavirus remain unknown, continued market volatility can be expected. With all these crosscurrents, it remains critically important to stay focused on longer-term fundamentals that should gradually improve.
WHAT YOU SHOULD DO:
Portfolio actions that you take (or don’t take) at this point can feel highly uncomfortable but the decisions are not rocket science. Investors were bailing on investment holdings at a near-record pace and then have been charging back in. This is no time to be part of the herd’s stampede in either direction. Although there is much we don’t know about the ultimate coronavirus impact, there is also much we do know. There is nothing unique about the list below, but it is supported by ample historical evidence.
-Stay the course. Fear and Greed are really the biggest risks.
-Don’t sell unless you have a dire need for cash.
-Rebalance the portfolio to restore beaten-down equity holdings to a weight consistent with your long-term investment objectives.
-If you have cash, then add to equity holdings on a systematic basis. This isn’t easy, but a good strategy is to make several smaller investments over time rather than one larger trade. No plan is fail-safe, but this strategy is a way to get into the market without making one big move.
– Remember that investment performance is improved by buying in bear markets, not selling.
-Dollar Cost Averaging that invests a predetermined amount of dollars on systematic predetermined dates is a method that remains a valid investment strategy.
Jeff Johnson, CFA
July 9, 2020