In Transition…but to Where? We Believe to a Good Place!

July 6, 2020
In Transition…But to Where? We believe to a Good Place!

“There is nothing permanent except change.”

      –  Heraclitus, Greek philosopher

First Half of the Year Review

The first six months of 2020 is in the bank and what a roller coaster first half it was! After suffering its worst first quarter performance since 1938 in Q1 2020, the S&P 500 generated its best quarterly return since 1998, advancing over 20% for the second quarter of this year.1 Despite the strong final three months to take us into the half-time locker room, the first six months of 2020 is being billed in the media as, “the worst first half to a year since 1999 for the S&P 500,” and journalists note that it was the poorest start to the year for the Dow Jones Industrial Average since 1987.2

The first half of 2020 also marked the period in which the National Bureau of Economic Research officially announced that the U.S. economy entered into a recession beginning in February, calling an end to the longest economic expansion on record…128 months.3 Never mind that this was a forced economic shutdown, not a normal business cycle disaster, and that it will probably be the shortest-lived recession in history. In our view, these negatively slanted summary comments and headlines in the media oversimplify and misrepresent what actually occurred. All the damage to the market was done in a very concentrated three-week period in the February/March time frame during which the S&P experienced a 34% peak to trough decline.4 Headlines at that moment pronounced this to be a definitive bear market and cautioned investors to run from stocks.  

We counseled clients to be calm and patient unlike during prior pullbacks in which we tended to be very bullish and advise buying on the dips. This time, we suggested simply holding your ground in equities and upgrading holdings as we found certain securities to be overly punished in “throw the baby out with the bathwater” style, while others were more deserved of sell-off and likely to face continued challenge. We were cautious on a near-term (2-5 month) basis and respected the uncertainties and significant unknowns around COVID-19, but we remained quite positive on equities in the longer term. We have maintained our 3500 target for the S&P 500 but just pushed it out to the mid-2021 time frame, versus our pre-coronavirus view that the S&P 500 would reach that level by calendar year-end 2020. This is only a very modest adjustment in timeline.

Our optimism was/is based on the equally unprecedented levels of monetary and fiscal stimulus, knowledge that the economy was in good shape and not on life support going into this health scare, that we were social distancing and shutting down to bend the curve, and that novel efforts to introduce therapies and vaccines were well underway. We felt the worst of the challenge would occur in the second quarter and we would begin transitioning to less-worse activity levels in the second half of the year and then to stable, and perhaps good, in 2021. And, we felt the market would sniff out this transition ahead of it happening. We’re glad we maintained this hold your ground view.    

Our main point has consistently been to avoid whiplash and head fakes in this time of a pandemic. The horrible return in the S&P 500 during Q1 2020 was quickly followed by the best two month stretch for the S&P 500 since 2009 during April/May and one of the best first phase recovery rallies on record from March 23, 2020, through the end of June…up more than 35% off the bottom. Regarding risk of whiplash, if you would have sold in March in the face of all the negative headlines, it would have cost you dearly and you would have missed the rally. Similarly, in the midst of the rally, experts were suggesting one should abandon growth stocks and turn in heroic fashion to value stocks. We believe a blend of both growth and value stocks is appropriate rather than extreme positioning…again to avoid whiplash and wealth destruction.

The bottom line is that we’re pleased with our hold your ground theme and adage not to mistake activity for progress. To paraphrase Charlie Munger, “Sometimes successful investing is just sitting on your arse.” We have refrained from major rebalancing or implementing major asset allocation shifts and that has worked well. After all, the market is only off roughly 3% through mid-year 2020 and up close to 7.5% for the 12 months ending June 30…does that sound like a deep bear market that requires major portfolio restructuring?5 Not to us. Some California chill has felt like the right side of valor to us.

Where Are We Now? In Transition

As the pre-Socratic Greek philosopher, Heraclitus, noted long ago—a la our quote above—change is constant…and that is certainly true in the equity markets. That said, there are periods of greater change and transition than others, and we appear to be in a period of heightened transition. We see it in the data in whiplash-like fashion as well and not just in the returns. Swings from 3.5% unemployment in February to more than 16% unemployment by April and then improved and back down to 14% by May, for example, as the economy shutdown. Other examples include retail sales that dropped a record level of 14.7% in April only to be followed by record sales gains of 17.7% in May.6

I could cite a plethora of similar swings in metrics, such as manufacturing and service level activity, industrial production, housing, earnings revisions, etc. In this more traditional data and in more esoteric figures, such as trends in open table reservations, we see tremendous transition from horrible to better…but far from back to the levels before coronavirus. There are plenty of green shoots, and the record level of stimulus is a big reason that we are managing this tough patch and transitioning back to higher levels and a big reason for our continued positive longer-term view. Thanks to income subsidies to consumers via the CARES Act and temporarily elevated unemployment insurance levels, average wages and personal disposable income levels are actually higher than they were before the shutdown. This has created huge bank deposit growth and a stash of consumer cash with the potential to drive consumer spending over the next quarter or so while we try to reopen the economy and get folks back to their permanent jobs.

Consumer savings rates have catapulted from the 8% level of income to 30%7…this is a significant plus for future spending. The questions are:

  1. Will a second wave in coronavirus cases derail the recovery?
  2. How swift and strong will the recovery be?

On the former, we think the answer is no based on economic trends we see at present and the capacity at a lot of our hospitals to manage an abbreviated spike in daily cases. On the latter, we aren’t looking for a V-shaped recovery, but more like a gradual Nike swoosh that should support an increase in earnings back to 2019-level expectations by 2022, and we think that is enough to support a healthy 3500 target on the S&P 500 by mid-2021.

What Has Surprised Us?

People often ask if we are surprised by the disconnect between the strong S&P 500 returns in the second quarter recovery advance (up 35% off the bottom in short order) when juxtaposed against the horrible economic news…the data releases that were not only recessionary but economic activity figures that were as low as 1940 levels in several cases. We are NOT surprised by this disconnect — the fact the market has recovered, yet the economic data is quite soft—because of the transitory nature of the issue (health scare and forced, temporary shutdown to invest in health versus a structural business cycle train wreck) and the unprecedented stimulus to get us through the soft patch.

Equally important, we know that the market responds to change in trend rather than trades on the absolute levels of the economy. Historically it has rallied time and again well in advance of nirvana as the data gets less worse and merely shows improvement in trend while still hovering well below prior economic activity levels. On this basis, the recovery rally has been quite normal. The market moves before the data is picture perfect. Nothing strange here.

What I’d have to say has surprised us is the extended length of this first phase recovery rally. It has lasted a bit longer than we would have expected. As the chart below illustrates, normally we witness a 10%-ish temporary correction in the S&P 500 after a strong advance like we’ve just seen, before moving onto higher levels over a longer-term, 6-12 month period.

S&P Forward Performance Following Best 65-Day % Changes (Top 10)

But this current advance looks to have some strength and legs to it. While it would be more normal to see a pause here, and we believe we’ll get one, we must accept it might not happen very soon. We might not see that temporary correction we have been anticipating. Quite frankly, we’re OK with that, because we believe our client portfolios are invested appropriately for their long-term goals and should respond well if the rally continues or if it pauses. They are positioned well, in our view, in the context of achieving our client’s long-term financial goals and that’s what it’s all about.

Wrap Up

We maintain our cautious stance regarding the near-term direction in U.S. stock prices and see more normal wall of worry risks over the next several months as angst over the impact of a heated presidential election nears and begins to take more center stage space in investor minds. Add this to risks associated with a potential second wave in the virus and the fact that normally investors take profits after a significant run in the market like we’ve seen in Q2. As a result, we think the more prudent focus is on risk management rather than aggressively seeking maximum return in greedy fashion at this juncture and over the next several months. That said, we are quite positive with healthy S&P 500 targets over the next twelve months. And we would applaud if our more cautious near-term view is wrong and too conservative. Thank you for your continued confidence!

1Wursthorn, Michael. “Stocks End Best Quarter in Decades, Defy Crisis.” Wall Street Journal, 1 July 2020, P. 1.
2“Squawk Box.” CNBC. 1 July 2020. Television.
3Davidson, Kate. “Recession in US Began in February.” Wall Street Journal, 9 June 2020, P. 1.
6Torry, Harriet. “Retail Sales Record 17.7%.” Wall Street Journal, 17 June 2020, P. 1.
7Yardeni June 26th Personal Saving Report

The S&P 500 Index is a market-value weighted index provided by Standard & Poor’s and is comprised of 500 companies chosen for market size and industry group representation.

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