by Brad M. Weafer, CFA Chief Investment Officer
Making sense of the stock market during the Covid-19 shut-down.
The rapid decline in stock prices in February/March that accompanied the shut-down of the economy due to Covid-19 has been replaced by a +30% rally off the low of the S&P 500. The index now sits “only” down 10% for the year. This is in stark contrast to what we are all personally experiencing in our daily lives. It is even more at odds with the weekly negative records being set by economic data.
This leaves many clients and pundits asking the same question; why is the market not down more?
Market Gains not Broad Based
While the headline index results may be perplexing, the makeup of what is driving the market higher makes more sense. A relatively small number of stocks have helped drive the lion share of the index gains. The impact of the shut-down is affecting companies in very different ways and some are actually benefiting in this environment. Microsoft CEO Satya Nadella said, “We’ve seen two years’ worth of digital transformation in two months”, and the company reported strong revenue growth results in a number of their business lines that benefit from people working remotely. Likewise, Amazon reported accelerating sales growth with increased internet shopping that many of us can personally attest to. The S&P 500 constituency is heavily weighted to these companies, 10% in MSFT and AMZN alone, as well as other large technology companies that have seen their profits largely unaffected. The Dow Jones Internet Index is up near 10% year-to-date and has outperformed the S&P by over 20% (see Figure 1 below). On the other hand, smaller companies have performed much worse as you might expect, with the Russell 2000 Index down 25% year-to-date, well behind the S&P’s negative 12% return. The small cap index has had zero price appreciation in the trailing 5-years, a period that saw economic expansion and a significant cut in the corporate tax rate. The performance of economically sensitive companies also lagged behind during the most recent rebound in the S&P. The KBW Bank index is down over 40% this year and is just off the low mark of the year reached in mid-March. The industrial sector is sending a similar signal. These are not encouraging signs per se, puts the recent rally in better context.
Positive Returns Amidst Bad Economic Reports is Actually Normal
The makeup of the advance aside, historically, equities perform well when economic numbers are at their worst. U.S. Gross Domestic Product declined 4.8% in the first quarter. This was only the 13th quarterly decline of more than 4% since 1940. In each of these periods, the S&P 500 advanced more than 10% over the following year (see Figure 2 below). In a similar vein, Strategas Research Partners commented last week that the strongest six- and twelve-month equity returns have historically followed the worst non-farm labor payroll reports. For equity markets, economic data that is improving matters more that if the data is bad in the absolute. After posting some of the worst readings on record for labor, retail spending, and manufacturing activity; it is reasonable to expect improvement. It may be difficult to rationalize the current market rally with prevailing sentiment, but the data supports it.
Reasons for Optimism?
While much of the country is either in lockdown or just starting the initial phase of reopening, it is easy to think negatively. The personal toll that the pandemic is taking makes it difficult to comprehend that things might ever get better. However, there have been several positive developments that provide some hope for the future. Mitigation steps taken by most states did as intended. Containing the spread of the virus was crucial to make sure the health care system was not overwhelmed. We have see the number of new cases declining in many of the hard-hit areas, most notably New York. The U.S. Federal Reserve has stepped up measures to enhance liquidity and ensure the credit markets can operate efficiently. The government has passed relief measures offering lifelines to affected businesses and citizens. While the economic cost is obvious, these efforts buy us time and we have seen encouraging signs on the scientific development of better testing, treatments, and vaccines. Looking to China, we now have some experience that once shutdown measures end, economic activity does resume. Things may seem dire today, but we would not bet against human ingenuity and spirit over the long-term.
Where Do We Go From Here?
We often preach on the merits of thinking about your investments on a long-term horizen. However, we recognize that in times of market stress, anxiety causes clients to question what long-term actually means. Predicting what twists and turns will befall the economy and the stock market is difficult in the best of times; it feels even more difficult today. There are very few historical situations with which to compare the current situation. Looking ahead, we fully expect the economy to recover, but the duration and path of recovery is much less clear. During enhanced level of uncertainty, companies that have shown the ability to withstand economic volatility are valued more dearly. Therefore, the types of companies we are attracted to for investment, those with strong and stable profitability and secure balance sheets, are now trading at multiples that are less attractive than normal.
Our outlook for equities is more subdued as a result and we are forced to be more patient as we wait for fat pitches. We are investing more cautiously and selectively than is typical and our equity strategies hold more cash than usual. Things can and do change rapidly. We are not standing still and hoping for the best. We took steps to sell positions in companies where our outlook has deteriorated or where there was more than appropriate leverage for the current backdrop (live events and money center banks for example). We made selective investments with the proceeds of those sales into companies we thought are better positioned to ride out the storm and prosper when normalcy returns (internet infrastructure, insurance brokers and payment technology for example). While we are never pleased to see negative equity returns, we have been encouraged by the defensiveness of our companies and the protection our differentiated portfolios have provided relative to passive index investments. We think author and motivational speaker, Zig Zaglar summed it up best when he said, “Expect the best, prepare for the worst, capitalize on what comes.” We cannot predict the future for the stock market with conviction, but we can continue to invest in high-quality companies, led by strong management teams, with solid growth prospects and secure futures.
Market Commentary Disclaimer: This publication is for informational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy or investment product. The information contained herein is the opinion of Boston Financial Management and is subject to change at any time based upon unforeseen events or market conditions.