A Smarter Way to Invest Market Summary 8-5-2020

The S&P 500 maintained a steady upwards trajectory for the month of July. While the index has not quite returned to its pre-pandemic highs, it closed the month within 115 points of that highwater mark and also above where it finished 2019. Overall, the index climbed 5.5% for July while the S&P 400 Mid Cap rose 4.5% and the S&P 600 Small Cap rose 4.0%. The imbalance between tech and industrial names continued with the Dow Jones gaining 2.4% for the month while the NASDAQ Composite gained 6.8%. At the sector level, the gains were felt almost across the board with 10 of 11 seeing increases. Utilities (XLU, 7.8%) and Communication Services (XLC, 7.6%) led the way while Energy (XLE, -4.8%) was the lone dissenter. Internationally, the MSCI Emerging Markets Index (8.4%) drastically outpaced the MSCI EAFE Developed Markets Index (2.2%) but both saw gains nonetheless. Fixed income sectors broadly saw positive total returns with high yield corporates (HYG, 4.6%) leading the pack. Intermediate treasuries (IEF, 0.8%), investment grade corporate (VCIT, 1.8%), and aggregate international bonds (IAGG, 0.4%) also had positive returns. In a move that may speak to longer term expectations, alternatives took a large leap forward this month with gold (GLD) soaring 10.8% and the commodity ETN DJP (7.4%) not far behind.

The main impediments to a continued ascent seem to be twofold right now; Chinese relations and renewed fiscal stimulus. On the Chinese front, flames that seemed to be snuffed out by January’s trade deal were fanned by circumstances surrounding the origins of the pandemic and subsequent dissemination of information or lack thereof and fully reignited by China’s actions pertaining to Hong Kong. In Hong Kong, China has implemented its new national security law aimed at cracking down on pro-democracy sympathizers¹. Under the new rules, an arrest warrant was issued for a U.S. citizen born in Hong Kong, demonstrating how far the new law intends to reach². In retaliation, President Trump signed legislation to impose sanctions on China and an executive order that ended Hong Kong’s preferential treatment, putting it on the same standing as mainland China³. Subsequently, the U.S. ordered the Chinese embassy in Houston to close amid allegations of stealing scientific secrets⁴. China retaliated in short order by ordering the U.S. embassy in Chengdu to close⁵. Also caught up in the tangled web of retribution is popular social media app Tik Tok. Allegations that it was sharing data with the Chinese government led India to ban the app within its borders with Australia considering a similar policy. Different branches of the U.S. military and some U.S. companies had already placed bans on the app but President Trump was deliberating a national policy before reports surfaced that Microsoft was in talks to buy the app’s U.S. operations which would supposedly put an end to the data sharing concerns⁶. The important takeaway from all of this is that tensions are escalating and the market is anxiously keeping an eye on new developments.

At home, the main focus has been on a second round of fiscal stimulus and what form it will take. The end of July was an important deadline for the initial wave that resulted from the CARES Act back in March. That legislation contained elements of relief for individuals in the form of one-time stimulus checks and enhanced unemployment benefits, and for small businesses in the form of the PPP lending program while the Federal Reserve provided unprecedented support for securities markets. These were all in response to the anticipated plunge in economic activity as shutdowns around the globe took their toll and the data seems to indicate that they were effective. Looking back at various measures you can see the steep initial drop in March followed by equally dramatic subsequent rebounds. A good demonstration of the effect that the stimulus has had on individuals is in a comparison of retail sales against wages/salaries and wages/salaries plus unemployment insurance⁷ (click through the footnote link for a graph of this data). As expected, all three of these figures were drastically reduced in April. But two of the three data points saw dramatic improvements in May.

• Retail sales are a good indicator of economic activity because about 70% of our GDP figure is driven by consumer spending. If people are spending, the economy continues expanding. This statistic recovered nicely from the dip as people continued spending at a slightly lower level than pre-pandemic, but much higher than April
• Total compensation also saw a sharp spike in May. This figure includes wages or salary as well as benefits from unemployment insurance. With the initial round of stimulus, those who lost their job were able to retain (or in some cases improve) their spending power along with those who still had their This is likely what fueled the recovery in retail sales above
• Wages/salary was the one data point that did not If wages and salaries remain depressed (corroborated by the depressed employment statistics), that means that the jump in total compensation detailed above was fueled largely by the temporary increase in unemployment benefits. If those expire without further stimulus you run the risk of total compensation falling again along with retail sales and the economy as a whole

This is where we currently stand and why the concern is so high. As negotiations for the next round of stimulus resume, the idea that some level of stimulus is needed has bipartisan support but negotiators are standing firm with their side of the aisle on various discrepancies including jobless aid for individuals, liability protection for businesses, and aid for state and local governments⁸. Democrats want to retain the current unemployment bonus of $600 per week until state unemployment levels fall but Republicans want to reduce that amount. While the extra money does seem to have bolstered the economy in the short-term, there is anecdotal evidence of people being disincentivized from returning to work because their total compensation will remain higher by staying on unemployment. This also ignores the discussion of what impact this has on the nation’s financed in the long-term as economic principals suggest that we will eventually face a day of reckoning after printing all of this money.

Finally, there is another interesting dynamic at play in the current market surge that is worth discussing. In the wake of the dotcom bubble and the great recession, retail trading had fallen to about 10% of market volume in the U.S.⁹ The memory of large losses and the rise of indexing and ETFs likely accelerated the decline. In the ten plus years since, however, the individual trader has made a comeback, now accounting for 18.5% of U.S. market volume. That represents a level of volume similar to what hedge funds are responsible for. The spread of commission-free trades, investment apps like Robinhood that allow fractional trading, and the lack of sports to gamble on may all be feeding this paradigm shift.

The reason this is notable is that an influx of money like this leads to a surge in prices. New money needs to go somewhere and if volume data is any indicator, these retail assets are being allocated based on popularity and not necessarily fundamentals. As this detachment between prices and fundamentals continues, you get a degree of market melt-up that usually leads to a melt-down at some point in the future. This, along with the stimulus debates outlined previously, could be the catalyst for the next leg of market movement but only time will tell. Few people probably would have predicted that the market would positive for the year given the current environment and the path forward is equally unpredictable.

Adam Blocki, CFA, CFP®

Sr. Portfolio Manager