MARKET RECAP: The prevailing theme for the stock market in the third quarter was a familiar one – the dominance of the largest five S&P 500 stocks (Facebook, Apple, Amazon, Alphabet and Microsoft). Much was made of the 6% decline in the shares in September, yet Big Five Technology still managed a gain in excess of 12% for the quarter. Their average gain for the year is a staggering 40%, and with a 23.4% capitalization share of the S&P 500 they continue to inflate the index’s return. For the third quarter, the S&P 500 posted a total return of 8.9%, bringing the gain for the year to 5.6%. This is highly unrepresentative of average stock performance, though, as the equal-weighted S&P 500 posted a decline of 4.8% for the year.
The bipolar nature of the 2020 stock market is clearly illustrated by the huge performance gap between growth versus value shares. While the S&P 500 Growth Index has gained 20.6% for through 9/30, S&P Value has declined 11.5%. The 32% performance spread is the widest divergence since 1979. Growth performance has, of course, been highly influenced by the run for Big Five Tech this year, but has also been magnified by amateur investors trading on such free online platforms as Robinhood. The armchair set has emerged as a market force now rivaling the entire hedge fund industry in volume. High-profile beneficiaries include Tesla, which is now more valuable than Ford, GM, Toyota, Honda and Fiat Chrysler combined (despite selling less than 2% of the autos of the bunch). Also of note is Snowflake, a niche cloud computing operation whose IPO on September 2 rocketed 112% in one day, making it more valuable than Uber, GM or Dell. Market moves such as these defy basic logic and are very concerning to us.
Yields for Treasury bonds were unusually steady during the third quarter, with the 10-year hovering around 0.7% for the entirety. For corporate issues, though, credit spreads over Treasuries narrowed approximately 30 basis points (0.3%) during the quarter, juicing the overall bond market return well above its meager income component. As measured by the Barclay’s Government/Credit Index, bonds delivered a total return (income plus appreciation) of 0.8% in the third quarter, padding their return for the year to a generous 8.0%. With an elevated duration of 7.5 years for the Index, though, the return is extremely fragile. A mere 1% rise in interest rates and it all but disappears.
ECONOMIC FORECAST: The first round of governmental stimulus in March led to a robust recovery in discretionary consumer spending. Industrial activity also rebounded, as companies worked to fill backlogged orders and rebuild inventories depleted during the shutdown. The combination led to a third-quarter GDP forecast exceeding 30%. If correct, it would bring total economic output back to 85% of pre-pandemic levels. The wild swings in demand, coupled with a damaged supply chain, have stirred inflationary spirits, with quarterly CPI estimated to have increased by 1.2% (or 4.9% on an annualized basis). However, we expect inflation to normalize over the coming quarters to somewhere closer to the Fed’s 2% target.
While tremendous progress has been made to date, the speed and shape of a full economic recovery will hinge on future fiscal policy decisions. Our current thought anticipates a “K-shaped” recovery with some sectors of the economy performing spectacularly while others falter. Many consumer-facing industries are likely to struggle until public confidence to safely congregate returns. Airlines, retailers, restaurants, and other travel & leisure businesses, which provide millions of jobs, will need a bridge if they are to survive the downturn. While there are varying opinions on the need for more economic assistance, Federal Reserve chairman Jerome Powell has argued some additional support will be needed to avoid a protracted recovery. There are undoubtedly real economic consequences to weigh before adding further strain to governmental budgets. On balance, we believe a smart package of additional support is warranted to avoid a lengthy recovery like the US experienced after the Great Recession.
FIXED INCOME STRATEGY: With the 10-year Treasury yielding only 0.7%, there is not much remaining upside for the bond market. Negative interest rates such as in Europe are certainly possible, but the odds seem remote given moderate U.S. inflation rate and the growing mountain of Treasury debt. The market seems to agree, as the yield curve holds the most upward slope since 2016 – indicative of expectations for future economic growth coupled with price inflation. We concur, and believe the most likely scenario is for rising U.S. interest rates as the economy gradually rebounds from the virus’ sucker punch and more government red ink is spilled in the form of fiscal stimulus.
As conservative investment managers it is no surprise we are quite cautious regarding maturity structure and are focusing new purchases in the short-term one- to three-year tranche. While we wish it was financially rewarding, it is closer to a risk management exercise. Yields are dreadfully low, with the two-year Treasury yielding only 0.1%. We are finding slightly better value in corporate issues, but investment grade issues such as a JP Morgan bond maturing in 2022 only carries a yield to maturity of 0.33%. Sadly, bonds are a non-functioning asset class – high risk with little to no potential for real return.
EQUITY STRATEGY: Although the world economy has been quelled by the virus and the human toll continues to mount, the U.S. stock market somehow managed to set an all-time record on August 8. The round trip from its 20% drop in March only took 126 days, the fastest rebound from a bear market in history. Unfortunately, though, it has not been an earnings-led recovery, and forward price/earnings multiples have expanded in excess of 20x. This has only happened once before, during the tech bubble of 2000. It is not surprising that we are on high alert, as it appears too much has happened too fast (and at too high a price).
We detailed our equity positioning in a report published September 1st (link), including a defensive overweight in healthcare and a recent underweight in the red hot technology sector (where the P/E ratio for the Big Five names has bloated to 40x). Since then we have become increasingly careful, and have added another increment in healthcare exposure and have recently overweighted the defensive consumer staples group. We have also made moves across the portfolio in preference of dividend yield. Stocks are richly priced and upside potential seems limited; we would like to at least be paid to wait while the economy grinds back to life and corporate profits recover.
ASSET ALLOCATION: Our outlook for the economy and asset classes is a bit dreary, and a contentious election awaits, but the asset allocation call easily reveals itself through the process of elimination. Longer-dated bonds appear to be a trap. With interest rates so close to zero across the curve, they do not have enough potential “shock absorber effect” for adequate downside protection in the event of a double-dip recession or political unrest. From a quantitative stand, stocks still offer an expected return that is two standard deviations above the historic mean. Political uncertainty amplifies stock market volatility, so putting the election behind us should have a calming effect. After taking all into consideration we are targeting an overweight position in equities of plus 10-15% versus benchmark.
Portfolio risk is being minimized by a very conservative fixed income maturity structure and an increasingly defensive equity strategy. Since the fixed income option is basically a broken asset class, we are also classifying some equity selections as a “bond proxy”, where the shares effectively emulate the income function of a traditionally safer fixed income option. In the end, our model equity portfolio now yields 2.1%, exceeding the 1.9% yield of the S&P 500 and well in excess of the 1.2% yield to maturity of the benchmark bond index.