July 23, 2020 – Back to School & The MarketsSubmitted by Alsworth Capital Management, LLC on July 23rd, 2020
Virtually every sector of the market was up in the second quarter of 2020, defying negative economic news and an explosion in COVID19 cases. Large US companies, represented by the S&P 500 Index, were up 21% over the quarter and are now down only 3% for the year. Developed international and emerging-market stocks recovered 17% and 19% respectively, though they continue to be down around 10-11% from the start of the year. From the low point of the market on March 23rd, the US stock market has recovered a remarkable 40%, marking the largest rally ever, over such a short period of time. Investors have been encouraged by the sheer size of the stimulus programs and have been looking for any alternative to near zero interest rates now offered on bonds. In recent recessions, the playbook of dropping interest rates and unloading trillions of deficit spending on the economy has resulted in a speculative frenzy in stock markets and investors were not going to miss out on this opportunity again. As the market recovered, momentum has helped push prices even higher, as many investors suffered from “fear of missing out” on the rally and bought the most successful companies like Amazon, Microsoft and Netflix in spades. The level of deficit government spending and Federal Reserve asset purchases has far surpassed even what was spent in the entire 2008 Great Recession response, and we are just getting started. A second round of stimulus is being debated as I write this letter and “trillion” has become the new “billion” when the scale is discussed. This has all been music to the market’s ear, even as the underlying economy is in the thralls of a recession and uncertainty remains high.
While nearly everything was positive in the second quarter, the bulk of the year to date recovery in asset prices is concentrated in the largest, most growth-oriented companies. The financial sector (banks) is still down over 23% year to date. Energy stocks are still down over 37% and real estate is down over 16%. Positive sectors for the year include Technology, Healthcare and Precious Metals. The most cited benchmark for the US stock market is the S&P 500 index, which is a pool of the 500 largest companies domiciled in the US. When determining how much of each company to own in the index, they are ranked based on the total value of each company and weighted accordingly. Microsoft is 6%, Apple is 5.8%, Amazon is 4.5% and Facebooks is over 2%. The Technology sector in total represents nearly one quarter of the entire index. As such, it is heavily skewed by the performance of that one sector. Our large cap growth investments are up strong, since they are comprised largely of technology companies. However, our value-oriented positions (financials, industrials) and our smaller company positions have not recovered as well from the initial sell off. It really is a mixed bag despite the headline strong performance of technology companies.
COVID19 & The Economy
It continues to be the case that the single most important factor impacting the economy, the markets and public policy is the trajectory of the COVID19 pandemic. The stock market rebound is indicating that investors are forecasting a quick economic recovery and that the virus will be contained soon. To justify the strong recovery in technology companies, you would need to assume that companies will ramp up employment quickly to provide the income needed to support economic recovery. The market consensus at this moment is that the recent spike in coronavirus cases will taper off and that our healthcare systems can manage the influx of new cases. It also assumes that improved treatments will keep the death rate low enough to avoid driving consumers back into shutdown mode. It assumes that progress on a vaccine will be swift and ready for distribution by early 2021. It makes the implicit assumption that the vaccine will be widely disseminated and accepted by over 60% of the population, to reach herd immunity levels sufficient to control the spread. These are some optimistic assumptions, but they also seem plausible. This optimism is clearly reflected in technology company stock prices, however, a more cautious outlook is reflected in the pricing of energy and consumer discretionary sectors of the market, where the consequences of being wrong are more dire. If we, in fact, see the bullish case play out in the coming months, the weaker areas of the market, like energy and financial stocks will likely catch up to technology companies and recover more of the recent declines. The underlying economy would also pick up and we would again approach full employment (low unemployment rates). If the rate of viral spread continues to grow out of control with the absolute number of death and long term injury rising by the tens of thousands, I would expect the recession to extend much longer and there would be a risk that stocks could give up some of the recent gains. We can do a lot to provide stimulus to replace lost income and address dysfunctional market pricing behavior. However, there are costs associated with rising debt levels, especially considering we had already borrowed trillions of dollars to fund a tax cut in 2018, when things were going well. Government deficit spending has a place, but it can’t replace a normal functioning economy.
Like you, I continue to muddle through a multitude of choices every day on how to be COVID19 safe, while keeping my sanity and some semblance of a normal existence. For me, it involves constant trade-offs, many compromises and some self-justification for allowing social interactions. As more time goes on, it becomes harder and harder to maintain full adherence to social distancing and isolation. We each make our own decisions on how much exposure to risk with varying degrees of confidence. I know that avoiding crowds and keeping six feet of distance is wise. I know that wearing a mask, if I’m in a confined space is prudent. However, there is a lot of gray area in the decisions of how much social interaction to have with friends and family outside of your household. Now multiply those decisions by 350 million citizens of the US. As a country, we are making these choices largely on an individual basis and there are a host of complicated factors that influence each individual’s assessment of risk. While the proper amount of isolation versus indifference is hotly debated, our country is facing an alarming spike in COVID19 cases since coming out of lockdown. Our numbers are quite a bit worse than most other developed countries, regardless of whether we measure on an absolute basis or adjusted for population size. This fact has given me reason to be somewhat skeptical of the most optimistic recovery scenarios.
Looking forward to the third quarter, one of the most consequential decisions will be how to re-open our schools. It is a complicated decision with tough consequences no matter what conclusions are ultimately drawn. It seems quite logical that as we put children together in a confined space, they are going to spread COVID19 and every other contagious malady and bring those illnesses back home to their family, where it will continue to spread throughout the adult population. An interesting chart that caught my attention was of the average daily confirmed COVID19 cases in Israel leading up to then following the opening of schools.
Determining how to safely open-up schools is going to be a very difficult decision that will require lots of funding and close attention. There will be significant economic impact if schools are not allowed to open and parents have to stay at home to watch their children. There will also be enormous economic impact if the coronavirus continues to spread out of control and we are forced into lockdown again. I am confident that we have the resources, the aptitude and the will to solve these problems. We have time left to bend the curve on the viral spread to keep it together long enough to develop better treatments and ultimately to distribute a vaccine.
The technology sector of the US market is trading at bubble level valuations. The story behind why you would want to own large growth technology-oriented companies is compelling. However, the prices they are trading at require financial gymnastics to justify. We have been slowly reducing the allocation to this portion of the market, which has done very well year to date, so that we can realize those gains. We continue to hold mature value stocks in the portfolio to have exposure to stocks that should recover in our most bullish scenario. We continue to slowly add to our Gold position and international holdings, which we expect to benefit from a weakening dollar and the future impact of a rising US national debt. We continue to look for opportunities to utilize the recent recovery in riskier asset classes and replace those holdings with higher quality more stable positions. We will continue to “sheer the sheep” when there are gains. I appreciate that you chose not to kill the sheep during the downturn and sell off your portfolio. We have recovered quickly, but there may be more volatility ahead. I recommend that we keep the sheep, find the best way to educate the children, and keep a diversified flock to withstand any scenario the future holds. There will be portions of our flock that excel while other portions mature and slow. Our job is to manage for an uncertain future, rather than managing for the recent past. This requires being prepared for all scenarios.
Please call, write, email, or request a web meeting anytime!
Shane M. Alsworth, MBA, CFP®, CLU®, CIMA®
The views and opinions presented in this article are those of Shane Alsworth only
Investments are subject to market risks including the potential loss of principal invested.
Asset Allocation does not assure or guarantee better performance and cannot eliminate the risk of investment losses.
Sources: Morningstar/Ibbotson data, Ned Davis Research, BCA Research, Litman Gregory Research