Market Summary: As we re-capped in part one of our Commentary last week, the first half of 2020 was a wild ride for stock investors. After a disastrous first quarter loss of 19.6% for the S&P 500 index, stocks staged a remarkable comeback. A second quarter gain of 20.5% narrowed the Index’s loss for the year to only 3.1%. However, gains were highly concentrated in the FANG stocks (Facebook, Amazon, Apple, Netflix, Google and Microsoft), and due to their size (25% of the Index’s total capitalization) the return was skewed upward by roughly 7%. For a truer measure of “average” stock performance refer to the equal weighted S&P 500 index, which has declined 10.8% for the year.
While the stock market gyrated from bull market to bear and then back to bull again in a period of only six weeks, the bond market was a consistent winner in the first half. The arrival of the coronavirus brought an end to the long economic expansion, and there was an immediate migration from risk assets. As a result, the yield on the 10-year Treasury declined to a record low of 0.31% on March 9. During the second quarter of 2020 rates actually rose a bit, as signs of economic recovery began to emerge. This led to a pronounced contraction in corporate bond spreads, though, and the bond market was able to manage further gains. As measured by the Barclays Government/Credit Index, bonds delivered a total return of 3.7% in the second quarter. This brings their 2020 return to a bulky 7.2%.
Economic Forecast: Economic forecasting is difficult enough during normal times, but in the absence of reliable data it is currently a finger in the wind exercise. The most glaring example of bad data comes from the May jobs report, which showed the U.S. adding 2.5 million jobs versus an expected 7.5 million loss. This was the biggest data surprise of all time, but it was skewed badly by counting millions of workers on unpaid furlough as employed. Another head fake investors will have to deal with is the fact that quarterly GDP releases are reported on an annualized basis. In all likelihood the U.S. economy will actually decline 10% on a peak-to-trough basis due to the coronavirus. However, when annualizing the rate it is calculated as four quarterly 10% declines. The end result is a preposterous 46% reported decline.
What is clear is that the economic outlook will be highly influenced by the path of the virus, and with the recent spike in U.S. reported cases our optimism has been tempered. Although the case rate is influenced by increased testing and the fatality rate is declining, the bulk of consumers remain very wary to return to past behaviors. Visions of a V-shaped economic recovery appear unrealistically hopeful until a reliable vaccine or treatment emerges. Our base case is that the economy has bottomed, and in the end we expect an economic decline around 5% for the U.S. in 2020 followed by a strong recovery in 2021 (albeit from a depressed base).
Fixed Income Strategy: Although the index return indicates a banner year for bonds, keep in mind the real action has been at the risky long end of the yield curve (over 10 years in maturity). For the intermediate 2-10 year sector gains have been more muted to 5.3% for the year. As conservative investment managers we are a bit handcuffed by our low risk tolerance, and are directing new investment into the one- and two-year sector. Regarding risk, with yields bound so closely to zero the entire yield curve is a study in return-free risk. In the case of the 10-year Treasury, it currently yields a paltry 0.6%. The virus will almost certainly run its course well sooner than in ten years, and barring economic meltdown, the rate of inflation should easily exceed such a minuscule yield over the term. It is therefore a virtual lock as a losing long-term investment. Instead of chasing tiny yields we are focusing on managing risk at this juncture, and are minimizing portfolio risk by maintaining a very conservative maturity structure. We hate to sound ominous but there is a high probability of a bloodbath for yield-hungry bond investors swimming in the long end of the yield curve.
Equity Strategy: The market of the late 1990’s was led by the technology sector, as well as a select group of the largest companies. This was a time of moonshots for now-defunct darlings such as American Online, Yahoo and Pets.com, and a period of 30x P/E multiples for even mundane issues such as Coca-Cola, Procter & Gamble and Gillette. While we are not overlooking the earnings power of today’s FANG stocks, we must note the divergence in NASDAQ as a tech stock proxy versus the S&P 500 is the widest since 2002. Meanwhile, slow and steady names such as Walmart and Procter & Gamble are trading at an inflated 24x forward earnings – eerily retrospective of the mega caps at the end of the 1990’s.
Our reaction, as always, is to remain true to our valuation-oriented roots. As conservative investment managers the result is a broadly diversified portfolio of over fifty relatively safe, inexpensive names with sound balance sheets. The portfolio includes positions in all five of the largest technology stocks, but it is a stretch for our diversification restrictions to even maintain 3% positions given today’s inflated valuations, let alone the 5%-plus cap weightings of an Apple, Microsoft or Amazon in the S&P 500. When the euphoria fades we expect similar results to when the tech bubble popped in 2000. Over the ensuing 2001-2002 period valuation returned to vogue and our equity selections out performed by nearly 11%.
Asset Allocation: Never have the Wall Street adages of “there is no alternative” (aka TINA) or “don’t fight the Fed” held more sway for investors than in today’s historically unprecedented investing climate. Regarding TINA, bonds are simply not a total return alternative. For the Fed, they have made it clear they are willing to offer an open-ended backstop for the economy and credit markets. Should the stock market crater it is conceivable they will add equity shares to their vast portfolio of holdings as well. From a valuation standpoint, equities trading at a P/E multiple of 22x are a bit rich, but today’s microscopic bond yields imply a 150x multiple for the alternative investment class. The only thing holding us back from a maximum equity weighting in balanced portfolios is our conservative investing mandate. As such we will temper our return objective with the appropriate risk balance and maintain a target of +10-15% equity exposure versus our benchmark targets.