On the Road to Recovery? We Think So…But Not Looking for Instant Results!
“Take calculated risks. That is quite different from being rash.”
— General George Patton
The economic data released have been absolutely horrific in the second quarter. With well over 20 million American workers receiving unemployment benefits and a number of economic measures falling to levels not seen since the 1940s, and yet the market has rallied sharply over the last two months. After one of the worst single months in the market on record in March when the S&P 500 declined more than 12%1, this bellwether index produced its best two-month gain since April 2009 in the April/May 2020 period. Specifically, it advanced roughly 17.8% for the two months ending May 31 and was up more than 36% from its low on March 23…that is a “wow.”2
Other associated stats sure don’t feel like bear market data…at the end of May, the S&P 500 is down less that 6% on a year-to-date basis, down only roughly 10% from the Feb. 19 peak, and it is probably underappreciated and not well-known that it is up over 9% over the last 12 months!3 Quite frankly, this is hardly a buying opportunity of a lifetime, and we are pleased that our counsel to clients has been not to panic and sell back in the March mayhem, but to hold your ground in equities and upgrade specific holdings where possible, given that the baby had been thrown out with the bathwater in specific cases back then from our perspective.
We’ve often been asked, how the market can perform so well and be resilient when the economic data is horrible, and many unknowns remain regarding coronavirus and a potential second wave? Or, stated differently, how can we have this disconnect between the market and the economy? First, the market leads the economy and only needs to see a less-worse trend in the data, or a stabilization trend, to reassert its ascent. Historically, this has been the case as the chart shows below.
We suggest that, when reviewing the positive impact of the fiscal stimulus that the federal government has employed so far, perhaps the underlying economic power remains more solid than we appreciate. We recognize that this impact is generated from still impressive levels in personal income from unemployment insurance and the spending programs contained in the CARES Act passed by Congress rather than via earned wages. Further, the three visible drivers in the recent market rally have been at historically high levels of Federal Reserve accommodation and support and investor optimism that stems from both the promise of reopening the economy, as well as some positive early data in phase 1 studies associated with vaccine development.
And, on this latter point, there is some game changing work going on. Several of the more than 100 initiatives underway to develop a COVID-19 vaccine utilize novel gene sequencing technology rather than the legacy method of injecting a weakened virus into the body to develop antibodies4. Gene sequencing simply involves injecting the right series of proteins into people and, if successful, this process can be developed to scale much faster than legacy methods.5 This would be a silver bullet that would make recovery much swifter than anticipated. Currently Dr. Anthony Fauci says a vaccine could be developed by year-end.6
Bottom line is that all these supportive factors have indeed encouraged investors and also make our team positive on the market over the next 12-15 month time frame. That said, we caution against getting ahead of ourselves in the short term. Significant uncertainty and a lack of visibility in the true pace of the recovery remain as we reopen and reengage. Yes, investors may be reading and cheering the fact that, per TSA checkpoint data, the number of airline passengers is up four-fold over the last month, but that is at a low, with airline traffic still down more than 80% versus this time last year7. Restaurants are limited in most states to operating at only 15-50% of capacity, and with additional costs layered on to protect customers and employees, it is very difficult to make money at those constrained operating levels8.
Plus, 60% of Americans say they are reluctant to go to a restaurant just yet for dine-in service. I could go on, but the point is that it remains very unclear if the recovery will evolve via a “U,” a Nike Swoosh, a square root-looking pattern, or even something worse. Let’s not count our chickens before they hatch or perhaps follow Gen. George Patton’s wisdom above and strive to base investment decisions on calculated risk at this juncture versus rash emotion and get caught up in fear of missing out (FOMO). Hence, we maintain our “hold-your-ground” view, with expressed caution over the near term, but have positive expectations for U.S. equities over the longer term, with a 3500 S&P 500 target by the second half of 2021.
At this point, we see no need to rebalance portfolios. Stocks are in positive territory over the last year and quite frankly don’t require rebalancing. We don’t find it an attractive point to add equity exposure. At current levels, risk management to us feels like the right side of valor versus being greedy and focusing solely on maximizing return. Oddly, we’re just fine if we’re wrong, and the market is off to the races to higher highs at this point, because we did not reduce equity exposure when many experts were preaching Armageddon in early spring. We recommended to our clients that they hold fast to their stocks so they have plenty of equity exposure and should benefit accordingly if stocks do surprise us to the upside in the short term or in swifter fashion that we expect. We think it’s important to respect the near-term, downside risk that typically resides in the market following a rather explosive rally like the one we have just witnessed.
We’ve mentioned of late that we’ve been following the technical price trends in the market closely, as well as investor sentiment, to get a clearer picture of the market landscape during a period when the fundamental economic and earnings data is opaque and negatively impacted by significant transitory issues. At uncertain moments like this, we think following the technical backdrop can provide some helpful signals and cues about potential market trends. In the past, we’ve discussed the seven signals to look for in noting a market bottom. Based on that data, we do think the market became oversold in March and we have hit the bottom, unless a severe second wave in coronavirus develops…and that is not our base case.
Some of the positive signs we look for to signal potential longer-term (12-15 months) advancement in the market include a shift in leadership to more aggressive names known as higher beta stocks and in more high, growth oriented and cyclically oriented industries such as consumer discretionary, technology and health care versus more defensive oriented sectors, such as utilities and staples. We also look for small-cap stocks to lead large-cap stocks as a sign of increasing investor confidence and willingness to take risk.
The chart below illustrates that this shift in leadership toward more aggressive securities occurred in a big way with high beta stocks, for example, well outperforming low beta stocks from March 23 through end of May.
Another technical measure is that the percentage of stocks now trading above their 50-day moving average is also quite positive…95% of stocks are doing so at present and this is a historically strong figure.9 The good news is that when this happens, and it is rare, the market in the past has advanced by double-digit levels over the ensuing 12 months; but importantly, it has tended to consolidate and trade in a tight and flat trading range in the shorter term one to six months. Further, the table below shows that, after historical, robust, first-phase rallies have occurred on the heels of deep swoons (like the 35% drop we just witnessed in early spring) in the market, the S&P 500 generally corrects and sells off by 10%, on average.
This is one of the reasons we are cautious on the short term and would not be surprised at all to see a 10-15% pullback at any moment before we move on to higher highs and our 3500 S&P 500 target mid-next year.
The Wall Of Worry
As you know, we always keep tabs on what we call the, “rolling wall of worry”…the evolving but constant flow of nagging headline items that cause investor angst and that could cause trouble in the market. It seems like, for several months now, that wall has been all about one thing…COVID-19. We are now at a point where we believe that will start to change.
As we begin to reopen the economy and see some green shoots of stabilizing at some “new normal” level, human nature will take root. Yes, we’ll find some momentary reflexive relief, but then we will start to worry about other things…that’s just our DNA and what we humans do. And, many times, it’s for good reason. A healthy dose of skepticism is a good thing, just as long as it doesn’t lead to a perennial case of pessimism. After all, the market is up 75% of the calendar year, so pessimists generally don’t win the stock game. That said, there is plenty of stuff to worry about other than our health right now, and these items will begin to become more front and center. This wall includes such items as elections that could result in one-party sweeps…something Wall Street doesn’t tend to like; financiers seemingly prefer gridlock. Relations with China are deteriorating as I type…tariffs seem like child’s play compared to cold war-like issues, such as asserting that Beijing is bypassing the past, accepted principal of treating Hong Kong as an autonomous territory, fighting for domination of the new 5G world with significant national security stakes at hand, etc. And, of course, there’s the epiphany yet to come from realizing the potential implications of the fiscal debt our government has appropriately taken on to help us get through this health challenge. We do think these headline issues will be resolved in sufficient fashion in due course, but these items give us pause in becoming more bullish on the market in the short run. Interestingly, even if the coronavirus issue wasn’t out there at all, given that the market is only off 6% YTD on the heels of 2019’s stellar 31.5% return, we would be cautious on the short term.
As we gradually reopen the economy, the market has a pelagic feel to it…likely to be a bit adrift in the open sea, that is, for a time, and perhaps directionless in the short term. To evaluate if the sea current is moving in the right direction, we will be monitoring things like usage of mass transit, Open Table reservation volumes, growth in mortgage applications and new home sales, volume of cars in parking lots near shopping areas, etc. Yes, we’ll monitor more standard, traditional economic metrics that are valuable as signals of normal business cycle trends, but it will be the aforementioned items that provide clues as to whether our positive, longer-term outlook should continue to hold as it does now. Data is getting less-worse but we continue to respect near-term challenges…hold your ground!
2Barron’s, June 1, 2020, “Rally Could Linger a Few Weeks, but Keep your eye on the data”
3Factset (see chart below)
4The Wall Street Journal, May 15, 2020, “Hedge Funds Expect a Cure but Weary of Betting Big”
5The Wall Street Journal, May 19, 2020, “Moderna Says ‘Data shows promise’”
6The Wall Street Journal, May 28, 2020, “Fauci says Drug Touted by Trump is Ineffective on Virus”
7Strategas Investment Strategy Report, May 18, 2020, “GDP vs. THE S&P 500”
8The Wall Street Journal, May 29, 2020, “Restaurants Wrestle with new Model”
9Strategas, Chris Verone Technical Strategy June 1, 2020
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. The Russell 1000 Index is an index of approximately 1,000 of the largest companies in the U.S. equity market.
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