High Level Commentary

MARKET PERFORMANCE-As Of Friday, August 14, 2020

Major Benchmark Performance: Last 3 Last 12
 Months+ YTD Months+
Since: 7/31/20 4/30/20 12/31/19 7/31/19
As Of: 8/14/20 8/14/20 8/14/20 8/14/20
US Large Cap-S&P 500 3.11% 16.38% 5.57% 15.45%
US Small Cap-Russell 2000 6.58% 20.78% -4.69% 1.68%
Foreign Developed-MSCI EAFE 4.43% 15.31% -5.27% 2.66%
Foreign Emerging Mkts-MSCI EEM 2.19% 20.43% 0.45% 8.90%
US Bonds-Barclays Aggregate -1.14% 1.44% 6.49% 8.87%
Long Treasury-20 Yr+ US Treasury Bonds -4.57% -2.21% 21.19% 25.32%
High Yield-Bloomberg 4.69% 10.37% 0.71% 4.14%
Performance includes Total Return for January through July and preliminary price performance for August

2020 began aggressively with the S&P 500 hitting an all-time high of 3,386 on February 19.  The index then plunged in March due to the novel coronavirus and fears of a global recession.  Although the world is now in in the midst of a global recession, economic data is currently showing a faster economic rebound than first expected.  As a result, markets are moving up and the S&P 500 is actually positive on a year-to-date basis as of 8/14/2020.

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 up 5.6% YTD as of August 14.  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 4.7% so far in 2020.   Foreign developed equity is down 5.3%.  Emerging markets were the big surprise and are up 20.4% in the last 3 months.  Longer maturity U.S. Treasury bonds benefitted from declining interest rates and from investors seeking a safe haven, and are up 21.1% so far this year. Corporate bonds and especially high yield bonds declined sharply in March due to increasing recessionary fears, but have since recovered due to the Federal Reserve’s corporate credit support.

Economic Statistics are coming in better than expected.  Although economic statistics dropped sharply 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 10.2% for July.  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.

-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 18.3% 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, but June was also up an impressive 8.4%.  Sales growth has slowed, but July still came in at 1.2%.

-The Leading Economic Indicators came in at a positive 2.0% in June after rising 3.2% in May.  Before that, the data was negative with April down 6.1% March down 7.5%. 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 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 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, helped by  commission-free trades and accounts like Robinhood that are said to be having significant trading volumes based on inexperienced traders.

Fed “Put” seen as a Backstop:  the so-called Fed “Put” continues to provide investor support based on the widespread belief that the Federal Reserve will move aggressively to prevent or at least mitigate any deep market swoons.  Although there is no actual Fed Put trade, (Put Option trades offset market downside risk), Fed actions are seen as providing “Put-Like” protection against severe market declines.

Support for this Put narrative is evidenced by the recent massive $2.2 Trillion program and by the Fed’s statement to “do whatever it takes”.  The Fed commitment forced interest rates lower and bond prices higher (via Fed purchases that included corporate bonds and municipal bonds) after the precipitous March collapse in stock and bond prices.  Critics believe the Fed Put removes the market’s price discovery mechanism and it encourages speculative risk taking, and they cite the late 90s internet frenzy/crash and the 2008/09 financial crisis as examples.  Nevertheless, the Fed’s perceived Put-like role supports the perception that the Fed won’t let it get too bad.  In addition, traders often cite the old adage: “Don’t Fight the Fed.”

Virus resurgence-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 get move up on a short-term basis, but the longer-term performance might be a 5-7% average long-term return/year rather than the historic 10%/year return.

Corporate Earnings for the second quarter are expected to be down 35.7% compared to last year according to FactSet due to the negative impact from COVID-19.  Revenue is expected to be down 9.6%.  Although the earnings reports are down sharply from last year, there are beginning to be upward revisions for the third quarter.

Election Volatility:  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 to 28%, rolling back Trump’s 2017 corporate tax reforms.  Greater restrictions on corporate share buybacks are also likely.  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.  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.  Without getting into tax policy, it is safe to say that a large earnings decline caused by a corporate tax increase would negatively impact market performance.

Stock Market and Economic Disconnect: The markets were buoyed 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 has significantly recovered, 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. On 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 to deal 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 a proposed 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.

International: International support has also been swift and significant. The European Central Bank committed to buying Euro 750 billion of public and private debt in a move viewed very positively by the market. In addition, Germany announced a $160 billion program to fund social benefits and direct aid to virus hit companies. England, France, Italy, Spain, India, Japan and other countries are providing several hundred billion dollars of support as well. All told, there is a very significant and timely international response to deal with the COVID-19 outbreak.

Global economic growth weakened significantly in 2020.  The U.S. reported a 9.5% GDP decline for the second quarter compared to the first quarter.  The Eurozone recently reported a 12.1% GDP decline for the second quarter.  It is encouraging, however, to see the Eurozone Manufacturing Purchasing Managers Index for July come in at a positive 51.8.  China’s first quarter GDP was reported at -6.8%, the lowest level in nearly three decades.  However, China reported a 3.2% gain for the second quarter.  The International Monetary Fund released their June 2020 World Economic Outlook and it showed a global GDP decline of -4.9% for 2020 and a 5.4% recovery in 2021.  For perspective, global growth was 2.9% in 2019, 3.6% in 2018 and 3.8% in 2017.

What’s Next? 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.

There is an open question about whether the monetary and fiscal initiatives will be sufficient, or whether they are already too far behind the curve. Given the unprecedented nature of this pandemic, it seems prudent for our government and our health care providers to respond as aggressively as possible.

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 is really the biggest risk.

-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.

Although the coronavirus has dominated recent headlines, there are other factors that still impact markets:

China-China is once again facing protests in Hong Kong based on plans to impose new national-security laws.  China’s top legislative body approved a landmark national security law for Hong Kong on the eve of the 23rd anniversary marking the territory’s return to Chinese rule. The new law puts limits on civil liberties and Hong Kong’s independent judicial system.  When these new laws were announced by Beijing, President Trump withdrew Hong Kong’s special trading status.  As the protests continue, the relationship between China and the U.S. continues to deteriorate.  Nevertheless, it appears that the U.S.-China phase-one trade agreement will not be impacted and President Trump did not impose sanctions on Chinese officials or persons connected to the Chinese regime.  After nearly two years of negotiations, the trade agreement was signed on January 15. The deal called for China to increase U.S. purchases by $200 billion over the course of 2020 and 2021. The deal requires China to open their markets to financial services companies and it provides new protections for trade secrets and intellectual property. The deal surprised some observers because it left in place tariffs on $370 billion of Chinese imports to the U.S. Since these tariffs remain in place, it is seen by some as reducing the prospects for growth in business investment.  At this time, China has not made enough purchases to achieve levels specified in the trade deal, but COVID-19 is partly to blame.

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The “phase one” deal was seen as a good start, and set the stage for further negotiations for a phase two deal.  However, deteriorating relations between the U.S. and China have put trade negotiations on the back burner.  Any phase two negotiations will deal with more difficult issues including forced technology transfer, theft of intellectual property and Chinese government support of their state-owned enterprises. President Trump said remaining tariffs “will come off” if they are able to negotiate a phase two deal. Critics of the deal are skeptical that China will actually increase imports of U.S. goods and services by $200 billion, and they are pessimistic about achieving a meaningful phase two deal. President Trump is clearly using tariffs in the short-term to secure hoped-for greater tariff reductions in the long-term. The trade dispute has already hurt manufacturing and business investment, and estimates of a negative impact on U.S. GDP range to as much as -1%.  From a broader perspective, this deal clearly reduces the escalation of the trade war, and it should provide a boost to U.S. GDP.  Unfortunately, the coronavirus pandemic reduces China’s potential to meet the trade targets and contentious trade rhetoric is coming from both sides.

Markets were strong over the course of last year. Despite a volatile start to 2020, 2019 was a very good year. The S&P 500 large cap index was up a solid 31.5%, and the Russell 2000 small cap index was up 25.5%. Foreign market performance for the year was positive but trailed the U.S largely due to stronger economic growth in the U.S. The MSCI-EAFE developed market index was up 22.0% and the MSCI Emerging Markets Index was up 18.4%. Corporate earnings provided support for the market. Although third quarter earnings were down on a year-over-year basis, they were not down nearly as much as many market participants had feared. In addition, 2020 corporate earnings are expected to increase 9.6% according to FactSet. U.S. stocks were also supported by continuing corporate stock repurchases and significant foreign demand.

U.S. Treasuries: Interest rates were relatively weak in 2019. The 10-year U.S. Treasury bond started the year at a yield of 2.66%, but it dropped to 1.46% on September 4th. In addition, the 30-year US Treasury fell to an all-time low of 1.94% on August 28th.  Since September 2019, interest rates recovered somewhat, and the 10-year bond finished the year at 1.92%. Based on these interest rate declines since the beginning of 2019, long treasury bonds total return performance was up a hefty 15.2% for the year as bond prices moved up with the decline in interest rates. High Yield Bonds were up 14.3% for 2019 based on reduced fears of an imminent recession. Interest rates have trended down so far in 2020. Long treasuries have been impacted by the fears of the coronavirus causing weaker global economic growth and by a flight to quality. High yield bonds have been very weak so far in 2020 based on a global economic recession.

Inverted Yield Curve: Last summer market pundits and the financial press loudly touted the risk from an inverted yield curve-the abnormal situation where interest rates on longer-maturity 10-year US Treasuries are lower than interest rates on shorter maturities like the 2-year US Treasury note and the 90-day Treasury bill. Historically, an inverted yield precedes most U.S. recessions. Since last summer, short rates have moved down below the U.S. 10-year U.S. Treasury interest rate, so that the yield curve was no longer inverted. By January and February of 2020, however, the yield curve inverted again as longer-term interest rates dropped sharply. Although an inverted yield curve may once again be a precursor to a recession, it is important to note that the timing is hard to predict. Analysis from Credit Suisse shows that a recession occurs on average 22 months after the inversion. Moreover, stocks often to do well after an inversion with an average gain of more than 15% in the 18 months following the inversion. This means that an inverted yield curve is not a time to make rash short-term portfolio changes. Instead, it is more prudent to maintain a disciplined long-term perspective that maintains proper asset allocation, diversification and portfolio rebalancing.

The killing of Qassem Soleimani and Abu Mahdi al-Mohandes on January 2 caused a market downdraft and a spike in oil prices, but tensions have moderated since then. Only time will tell if there is additional retaliation and what will be the longer-term ramifications. This event follows the September 14th, 2019 attack on Saudi Arabia’s Abqaiq plant caused an oil price spike but oil supplies remain sufficient to meet worldwide demand. These two events are examples of geopolitical risk where the current level of complacency may give way to significant downside. It is ironic that crude oil has recently plunged to $20/barrel as Saudi Arabia and Russia are engaged in an oil price war and as demand has plummeted due to the global economic shutdown. Oil prices rebounded significantly in May due to production cutbacks and increasing demand.  It is clear that oil remains a volatile commodity.

The 2019 federal government fiscal year budget deficit ballooned to $984 billion up 26.4% and up $205 billion from fiscal 2018. Although total receipts were up 4.0%, outlays were up 8.2%. Individual income tax receipts were up 2.0% and corporate tax receipts were up 12.3%. The budget deficit is the result of large government spending increases and the 2017 tax cut law. One particularly troubling aspect of the budget deficit is the rapidly increasing interest payments on the accumulated government debt. The federal government spent $380 billion on interest payments on the debt and this will continue to grow rapidly as ongoing budget deficits add to the government debt level. Moreover, interest rates are low but may well move up in the future, and this will make the interest payments even larger. It was unprecedented for the government to run such a large deficit during a period of economic growth because spending on unemployment and other safety-net programs are lower and tax revenues are higher. Now that Congress has passed a $2 Trillion rescue package, deficits will be even larger. If there was ever a time for deficit spending, now is the time.

Despite the political rancor the U.S.-Mexico-Canada trade pact was approved by both the House and the Senate and signed by President Trump. In addition, the $1.4 Trillion appropriations bill was passed. This bill provides funding for domestic and defense spending through September 30, 2020 and avoided another government shutdown.

The UK Brexit separation deal was completed on January 31 after Boris Johnson achieved a large Conservative Party election majority. The Brexit withdrawal process began in June 2016, and trade negotiations with the European Union will be the next big issue. Trade terms will need to be negotiated by year-end 2020, so Brexit will continue to be an ongoing issue. Although a so-called hard Brexit was avoided, little progress has been achieved so far in 2020 in negotiations between the UK and the EU.

For more detail see:

Markets & Economics

Market Performance

Valuation

Cornerstone maintains significantly more data and graphs than what is presented in this website.  Contact Jeff Johnson regarding specific data questions and comments.

Yahoo Finance link is helpful for daily market activity:  http://finance.yahoo.com/