A Smarter Way to Invest Market Summary 5-5-2020

MARKET SUMMARY

Provided By: Adam Blocki, CFA, CFP® – Senior Portfolio Manager

In March, a new bear market was ushered in; in April, the bull returned…technically. As a 20% drop from previous highs signals a fresh bear market, so does a 20% rise from previous lows signal a fresh bull market. After dropping as low as 2,191 in March, the S&P 500 surged as high as 2,954 in April marking a 34% gain from the March low, well past the 20% needed to establish a new bull market. Despite this action, it is almost the consensus view on Wall Street that we are far from out of the woods. The term “bear market rally” refers to a short-term recovery   during a bear market that ultimately gives way to new lows. These are not an uncommon occurrence; the dotcom bubble and financial crisis both saw short-lived rallies that faded away. Given the uncertainty of our present situation, I don’t think that scenario is at all far-fetched this time around.

For now, however, the rally is    on. All major equity indexes rose for the month of April. Domestic markets seemed especially robust  with  the  S&P  500  (12.7%),  S&P  400  (14.1%),  S&P  600  (12.6%),  NASDAQ  Composite  (15.4%),  and  Dow  Jones Industrial  Average  (11.1%)  all  seeing  double-digit  gains  while  international  developed  markets  (MSCI  EAFE, 6.3%)  and  emerging  markets  (MSCI  EM, 9.0%)  lagged  behind.  All eleven  GICS  sectors  rose  with  the  much-maligned  Energy  sector  leading  the  way  (XLE, 30.8%)  while  Utilities  (XLU, 3.3%)  and  Consumer  Staples  (XLP, 7.0%)  brought  up  the  rear.  In the  fixed-income world, US Treasuries (IEF, 0.2%) seemed to take a breather from their March rally while investment-grade corporate (VCIT, 4.9%), high yield corporate (HYG, 4.4%), and international bonds (IAGG, 1.5%) all picked up the slack. Finally, gold (GLD, 7.3%) surged on worldwide stimulus efforts. That gain was offset by continued pressure on oil prices that brought commodities as a whole (DJP, -1.8%) down for the month.

April’s rally seems, on its surface, to defy economic reality. However, it is important to keep in mind the forward-looking nature of the stock market1. The price of stocks today is a reflection of expectations for future profits. March’s respective 35% and 45% peak-to-trough drops in the large and small cap S&P indexes were reactions to the expected future hit to revenue from shut-downs.  The April rebound is  looking  at  future  assumptions  of  what  a  return  to  normal  means  and  deeming March’s reaction to be overly pessimistic.

This resiliency has shown itself in varying ways across asset classes. With fiscal stimulus, monetary stimulus, and calmer heads all entering the picture since March, we have seen winners and losers start to separate themselves. A wide gap has emerged between large and small-cap U.S. stocks. At the high point of the April rally, the S&P 500 Large Cap Index was 12.9% off of its 2020 high while the S&P 600 Small Cap Index was still down 22.6%. Given the trends that have emerged in recent jobless claims data, I would venture a guess that the smaller companies on Main Street are hurting even worse. It seems that larger companies with cash resources and access to credit have been judged to be more able to bridge a short-term revenue gap while smaller companies are viewed as being less resilient to the interruption. With the brunt of layoffs coming in the service and retail sectors, many local and family-owned businesses are likely being hit the hardest, leaving large corporations looking relatively stable. Tech companies that depend more on digital revenue have also held up relatively well with the NASDAQ Composite less than 9% off of its record high at April’s peak.

Conversely, our perspective from today’s vantage may prove to be overly optimistic. As sectors of the global economy begin to re-open in May, the market will again adjust its expectations in light of new information. April strength might give way to renewed May volatility if attempts at returning to normal activity lead to a spike in new infections and shut downs are subsequently re-enacted. Only time will tell if the worst is behind us or if additional waves of infection await. With increased testing capabilities and contact-tracing technologies, we could optimistically see future containment efforts that are more localized with minimal nation-wide impact, leading to stability in asset prices.

While we still don’t have a complete picture due to lagged data, April gave us a glimpse of how bad the damage to the economy has been. Jobless claims have continued to defy comparison with the last 6 weeks seeing 30.3 million people file new unemployment claims2 (the highest 6-week total during the financial crisis was 3.9 million). Our initial reading of first quarter GDP saw  an  annualized  drop  of  4.8%3  (the worst quarter since  Q4  2008  at  -8.4%)  with  a  much  worse  number  awaiting  in  the  second  quarter.  Industrial production, durable  goods  orders,  motor  vehicle  sales,  and  many  other  data  points all showed precipitous drops as well. Most of these figures represent March data that only reflects the beginning of the true shut-down  impact.  The future  likely  holds  even  worse  numbers  that  rival,  and  possibly  eclipse,  those  seen during the Great Depression.

Despite this fact, the outcome may not be as bad   as then at the personal level. In the 1930s the economy was still on the gold standard with the creation of new money tied to the supply of physical gold. Untethered from that restriction, the Federal Reserve is free to print money at will in an attempt to brunt the economic impact on companies and individuals. With fiscal and  monetary  stimulus  freely  flowing,  references  to  “QE4ever”  and  memes  featuring  Fed  Chairman  Jerome  Powell firing money cannons have entered the financial zeitgeist. As part of their effort to support fixed income markets, the Federal Reserve  enlisted  help  from  BlackRock4.  The details  of  the  arrangement disclose  the  fees  that  the  asset  management firm can earn from the partnership, the scope of which extends to bond ETFs. Some have opined that this also opens the door for future equity purchases if the need for additional stimulus led to that extreme scenario.  While there will undoubtedly be a price to pay on the other side of this crisis for all of this additional spending, possibly in the form of higher taxes or fiscal austerity, it may also help us avoid the “bread-line” scenarios often associated with the Great Depression.

In the  U.S.,  this  fiscal  stimulus  has  come  in  the  form  of  direct  payments  to  individuals,  loans  to  small  businesses,  and  support to local governments with calls for even further measures. Subsequently, some complaints have surfaced as direct payments have been insufficient for some, unnecessary for others, and in some cases intercepted by creditors; the fund for small business loans was depleted within days while some publicly traded companies and hedge funds maneuvered their way through the rules to access funds. The example of Denmark may show a more efficient path for stimulus efforts. Their government is offering to pay companies 75% of the salary for any employees that are not laid off5. This circumvents the necessity of small businesses applying for loans, prevents businesses and individuals who don’t need benefits from getting them, and ensures that most workers remain employed helping to restore both supply and demand when their economy is resuscitated.

At the outset of the  pandemic,  there  were  many  people  hoping  for  a  V-shaped  recovery  that  mirrored  the  speed  and  severity of the drop. The longer these shutdowns remain, the less likely that scenario is. Our dilemma right now is certainly a delicate balance between the health and safety of the American citizens versus that of the economy. As the economic slump continues, pent-up  demand  starts  to  become  permanently  destroyed;   as  more  and  more  people  become  unemployed, the amount of friction preventing a return to normal increases. There comes a point where no amount of exuberant post-pandemic celebrating, and spending makes up for what has already been lost. Some have noticed signs of changing consumer  habits  emerging  in  the  form  of  voluntary  isolation  even  before  official  stay-at-home  orders  were  enforced. There will likely be a similar level of trepidation once things slowly begin to reopen as the last two months of forced change  weigh  heavily  on  the  minds  of  consumers  worldwide6.  The combination  of  reduced  demand  from  the  unemployed  and  reduced  demand  from  those  unwilling  to  put  themselves  and  their  loved  ones  at  risk  could  lead  to  a  prolonged recovery. The discovery and wide-spread distribution of a vaccine would likely lead to a collective sigh of relief from most, but the possibility also exists of lingering effects similar to those experienced after the Great Depression when personal savings rates significantly increased and reliance on borrowing dropped.

What we can be almost certain of is that some things will change for good. Supply chains will likely be revamped; the costs of pandemic-related regional shutdowns were unlikely to be a large factor in previous decisions but will now get increased attention. Foreign ownership of companies will also be more widely scrutinized. While this issue was already being more closely inspected  in  recent  years,  this  will  only  increase  as  the  pandemic  has  highlighted  the  importance  of  controlling access to critical goods in times of spiking demand. Production of goods may move closer to where they are ultimately consumed as  countries  prioritize  satisfying  local  over  foreign  demand.  As an  example,  3M,  a  U.S.-based  company  with manufacturing operations in China, had trouble getting N95 masks to their home country when Chinese officials blocked export efforts, citing local demand7. PerkinElmer had similar problems getting test kits shipped to the U.S.

In a positive spin, companies are  discovering their  ability  to  quickly  pivot.  Shoe companies have switched to making  protective masks8, breweries have begun producing hand sanitizer9, and car companies have pitched in to manufacture respirators10. The role of government in our lives may also be questioned as things that were unthinkable only two months ago such as universal basic income is suddenly front of mind for some politicians11.

Adam Blocki, CFA, CFP®

Sr. Portfolio Manager