2020: A Historic Year
2020 will be remembered as the year the coronavirus severely tested the basic freedoms and tenets of capitalism in the United States. The virus has proven to be highly efficient in disrupting many of the daily routines we typically take for granted. Like an engine needs clean oil to operate smoothly, the free movement of people, goods, and capital are key lubricants capitalism needs to operate smoothly. The virus is near-perfect friction to this free movement. As we have witnessed, businesses and education systems have difficulty functioning without free movement. Unfortunately, we have also felt the human tragedy the virus has created with nearly 775,000 deaths globally,5 a number that will sadly go higher. For investors, the result has been some of the largest and fastest swings in financial markets and economic conditions in history. Yet given all this bad news and volatility, the resiliency of our people and the capitalistic economy is truly amazing. In short order, doctors and scientists have developed 8 coronavirus vaccines that are in late-stage trials,1 and many new treatments for COVID-19 are being uncovered rapidly. Central banks and governments globally have also delivered unprecedented relief packages designed to bridge the gap until the virus can be brought under control and the free movement of the essential capitalistic lubricants can once again start flowing. In the United States, the Federal Reserve (Fed), Treasury Department, and Congress collectively acted more quickly and on a larger scale than ever before during the depths of the crisis in March. As a result, the S&P 500 is at all-time highs, bond markets are functioning well and many businesses that would have likely failed are able to continue operating and employing workers. We celebrate these accomplishments in the wake of the pandemic, but as investors we are most worried about what we see in the windshield rather than the rearview mirror.
Challenges Through Year End
There are several challenges that worry us as we consider the last 4½ months of 2020. The spread of the coronavirus and its impact on the free movement of people, goods, and capital is still clearly the major worry for us and most investors. Large uncertainty clearly remains given the second wave we witnessed in Florida, Texas, and California this summer. Now we face the fall with schools reopening and the typical flu season. Early evidence from public K-12 schools opening in Georgia and Mississippi, in addition to recent developments at the University of North Carolina at Chapel Hill, point to the reality that we are still far from having the virus under control. The 7-day moving average of new daily cases is still elevated at 51,153,5 and new death averages are not strongly encouraging either at 1,066.5 This is down from numbers north of 70,000 in late July,5 but the reduction only occurred because Florida, Texas and California had to reimpose free movement restrictions, which will undoubtedly start having negative impacts on labor, confidence and economic growth data into September. Obviously, as investors, we need the economy to remain mostly open and Congress to continue providing sufficient relief programs to households and businesses until a combination of effective vaccines and treatments can be broadly distributed. Whether this balance with the economy and relief programs can be maintained until then is the major risk investors face for the balance of the year from our view. It is likely to be a bumpy journey, but ultimately, we think it can be achieved.
High unemployment levels are another worry top of mind to our team. While a lagging indicator in many environments, we think people being able to freely get back to work will be particularly important for this recovery. July’s nonfarm payroll numbers showed some continued healing in labor markets, where unemployment levels have fallen from the highs of nearly 15%2 in April to 10.2%.2 10.2% is still a large number, however; 10% was the peak witnessed during the Global Financial Crisis for context.7 Additionally, the Challenger Jobs Cut Report for July showed a large uptick in announced job cuts at 262,649, up 54% from June’s 170,219, but still much lower than April’s 671,129.8 The NFIB July report for small businesses showed a modest increase in hiring expectations compared to June, but job openings fell marginally.9 Given our concerns about the virus as noted above, we will be watching such employment data closely. The reason we are focused on employment is that US consumers make up about 70% of the US economy, so structurally high unemployment would erode consumer confidence and therefore corporate earnings potential. The Bloomberg Consumer Comfort Index fell modestly last week in a sign labor markets and virus uncertainty may be reducing household confidence.10 This number had been steadily increasing from May lows prior to this report. Perhaps this is reflective of the rollbacks in Florida, Texas, and California in addition to unemployment benefit concerns with Congress. We think more relief from Congress is likely, however, which should help with both the unemployment and consumer confidence data moving forward, but this will remain a key area of concern for us. Clearly, the pandemic getting worse or a lack of effective vaccines and treatments by early 2021 would pressure these key measures and weigh on risk assets generally.
The 2020 Election
The November Presidential election is also a key worry for investors. Like 2016, this will likely not be a typical election. We think markets mostly know what to expect with a re-election of the Trump Administration. However, the Financial Times election poll tracker currently shows Joe Biden with a sizeable electoral advantage.11 With an approval rating of 38% on June 30th, history would suggest that the Trump Administration may have difficulties.12 However, it is plausible to us that voters may not blame the Trump Administration for the virus-induced recession and related volatility and choose to keep the status quo in an already chaotic environment.
Another key issue with this election season is the question of which party will ultimately control Congress. A Biden win and Democratic sweep in Congress could raise concerns around higher tax rates. Regardless of the outcome, post-election years tend to be positive in the post WWII era.11 Given the significant monetary and fiscal stimulus that has occurred with more still likely (more on that later), we will favor the historical data with post-election year expectations although this is an unusual election as noted. The stock market may be our best gauge for election expectations, however. The gain or loss on the S&P 500 in the 3 months leading up to the election predicted the outcome in 20 of the last 23 elections dating back to 1928. 13 When the market was positive the 3 months leading up to the election, the incumbent or incumbent party typically won. If negative, they typically lost. We like market-based indicators, so this will be an interesting way to follow this election season in particular.
Earnings, Cash Flow, and GDP
The price of the stock market relative to measures like earnings, cash flow and GDP are also a current concern for investors. The S&P 500 fell 35% unbelievably fast from February 19th to March 23rd but has since increased by over 50% to reach all-time highs on August 18th. The recovery took just 148 days and has been by far the fastest moves in both directions in market history.7 As remarkable as these moves are, the S&P 500 now appears expensive to us by most measures. It is presently trading north of 25 times trailing twelve months earnings when the 25-year average around is 17 times.7 The forward 12-month P/E is around 22.5 with a 25-year average around 167. The Cyclically Adjusted P/E ratio (CAPE) is at 31.15 compared to the 25-year average around 27. The Price/Cash Flow ratio is now 15.7 versus a 25-year average close to 10. Additionally, Warren Buffet’s favorite measure of valuation, the stock market relative to GDP ratio is at a record high of 171.5% as of 7/31/20.6 The ratio stood at 167.5% on 3/31/00, which is not a date we want to be comparing to given what happened next. What is different now that we must consider is that interest rates are being held at extremely low levels by the Federal Reserve compared to history. Higher multiples may be justified relative to longer-term historical metrics given this. How much so is the key question. Again, a lot will hinge on the ability of our society to overcome the pandemic and in what time frame that will occur. If we recover relatively soon and can resume the free movement required for capitalism, earnings may be able to grow into these higher multiples. If we are still in the earlier innings of the pandemic however, investors may deem these multiples as too expensive. Another issue, which we will shortly address, is whether inflation will remain subdued into the future, thereby allowing interest rates to remain low. If not, these multiples may again look too expensive. The bottom line from a valuation perspective is that while metrics are high relative to history, they may not be too high yet given where interest rates are. Valuation data is likewise never a good tool to use for considering potential shorter-term market movements from our view. But given the uncertainties we have outlined; valuations could become important quickly so we will continue to closely monitor these measures as news and interest rates inevitably change.
Inflation seems more like a potential issue in 2021 or later to us, but should we get an effective vaccine sooner rather than later, it could quickly start showing up throughout the economy. Since it can be a real enemy for investors, it warrants consideration now. As we will outline shortly, unprecedented amounts of monetary and fiscal stimulus have been injected into the economy. Most of it has only shown up in financial markets thus far as it likewise did following the Financial Crisis in 2008/9. Former Federal Reserve Chairman Ben Bernanke told Congress on July 17, 2020 that current stimulus efforts will not likely lead to inflation exactly like the aftermath of the Financial Crisis.14 We will generally trust his judgment, but should we get a vaccine in the shorter run, the massive stimulus efforts (much larger than the Financial Crisis) could leak out of the financial system and into the real economy. We think this would cause interest rates to rise quickly and the Fed to become more hawkish which could be detrimental to financial markets, particularly longer duration growth stocks and fixed income securities. The primary metric we will be monitoring is the velocity of money stock in the economy. In simple terms, it is a measure of how fast money is changing hands. Higher velocity equals higher inflation expectations. The velocity measure is presently at all-time lows15 as banks are not lending heavily. But growth in the money stock has increased at the fastest pace on record.10 Should banks start lending this growth in money stock more aggressively (leaking the stimulus into the real economy), inflation expectations could change quickly. Some market-based measures may already be showing signs that investors are expecting higher inflation. Prime examples include the 7%+ decline in the value of the trade-weighted US Dollar and the 30%+ rise in the price of gold since March 23rd.10 Again, we think inflation may be an issue in 2021 or later, but expectations may already be changing and would quickly change with a widely distributable vaccine in our view. This would be a challenge for the markets.
Other Technical Measures
Finally, some shorter-term technical indicators are flashing signs of caution in the coming weeks. This is not surprising, given how fast the market has recovered since the March lows. The relative strength index, for example, is showing overbought conditions.7 The Ned Davis Short-Term Sentiment Indicator is in “extreme optimism” territory,16 also indicating markets are likely overbought. Put/call ratios are pointing to excesses as well.7 Other longer-term technical indicators are more positive, so we highlight these short-term indicators as evidence that perhaps a breather in the pace of gains for S&P 500 may be in order. Investors should certainly consider these indicators if putting new cash to work in the near future.
Opportunities Through Year-End
While there are several key challenges that worry us, there are reasons to be cautiously optimistic that markets can remain resilient through year-end. Monetary and fiscal policy combined with vaccine potential are three important reasons to be optimistic. At the end of February of this year, the total amount of assets on the Federal Reserve’s balance sheet totaled around $4 trillion.3 By early June, that total had grown by 75% to north of $7 trillion.3 This represents the largest and quickest expansion of monetary policy in the history of the Federal Reserve. The sheer scale and timing of the increase, in addition to the forward guidance and commitment by the Fed to “do whatever it takes to sustain the recovery”, has been a major contributing factor to the strong rally in the S&P 500 and other financial assets since the March lows. The scale and timing are rearview mirror aspects at this stage and likely already priced into equity multiples in our view. However, we are keenly aware of the forward guidance and commitment aspects as we position portfolios for the balance of the year. We will take Chairman Powell at his word that the Fed will use all tools available to battle the pandemic. He likely has more ammunition in the monetary toolbox to utilize should economic conditions worsen. We think this clear support by the Fed is likely to continue to provide a backstop for equities for the nearer term.
Likewise, Congress implemented huge fiscal support through the CARES Act and other measures to the tune of $2.44 trillion, or nearly 12% of GDP.4 This fiscal stimulus has also been a key reason financial markets have responded strongly off the March lows. These measures have proven to be a key bridge for households and businesses to weather the virus until it can be controlled. Although further stimulus efforts are presently stalled in Congress (especially around unemployment benefits), we think another $1-2 trillion stimulus is likely by Fall at the latest. This key support for Main Street is also likely to continue supporting Wall Street into year-end.
There are also 8 Coronavirus vaccines in late phase 3 efficacy trials.1 Should progress toward an effective and safe vaccine continue as it has (most likely from our view), we think markets will continue to focus on the positive aspects of the market and economic data. Again, the fact that there are vaccines in stage 3 is likely already priced into market multiples, but further progress with wide-scale distribution for late 2020/early 2021 may not be priced. We think continued progress on the vaccine front will provide additional support for equity markets in the shorter run.
Martin Zweig is credited with the now famous investment adage “Don’t Fight the Fed.” In this environment, it seems to us the current playbook is “Don’t Fight the Fed or Congress or the Doctors and Scientists Working on a Vaccine”.
Beyond these three key pillars of support, however, there are several fundamental and high-frequency data points that point to an economy recovering from the virus-induced recession. The Institute for Supply Management’s July report on manufacturing, for example, showed the manufacturing sector expanding at an increasing rate. The July reading was 54.2% and has increased for three straight months.10 Likewise, the housing market in the US is strong with mortgage applications up 22% versus this time last year.7 Housing is obviously an important component of household wealth, so strong demand in the housing sector bodes well for the overall economy. Higher frequency measures of economic activity continue to show signs that the economy is recovering. Gasoline usage, TSA traveler traffic, restaurant dining statistics and hotel occupancy numbers are all showing strong signs of recovery though generally still far from where they were before the pandemic started. As Liz Ann Sonders likes to point out about economic measures, what typically matters for financial markets is if the data is getting better or worse rather than good or bad. These examples of fundamental and high-frequency economic data appear to be getting better, which we think will support equity markets through year-end.
Bottom line, when we think about the key challenges outlined in conjunction with the opportunities, it is difficult for us to be too bearish or bullish on equities for the balance of 2020. If stimulus stays in place and vaccine progress persists, markets are likely to continue “looking through” bad news and focus on the possibilities of less virus friction in 2021. To that end, while we are concerned about some short-term weakness with equities given the technical indicators highlighted, we would not be surprised if markets continue to rally toward 3500-3600, particularly after the election. This of course implies limited upside with the S&P 500 trading around 3375 presently.7
Portfolio Strategy and Positioning
During these turbulent times, we are especially grateful for the trust you have placed in us to manage your finances. We have made four strategic adjustments to portfolios since January. Our overweighting in healthcare and technology along with our fixed income adjustments shift to longer-term Treasuries and U.S. investment-grade credit have kept our portfolios outperforming their benchmarks on a risk-adjusted basis. As the developments discussed above unfold, we will continue to proactively adjust portfolios as the need arises. If you have questions in the meantime, please contact your advisor.
4. JP Morgan Guide to the Markets 8/18/20
6. Ned Davis Research-“This Time is Different” published 8/12/20
7. Factset 8-18-20
10. Bloomberg 8-18-20
12. Ned Davis Research 2020 Election Handbook
13. https://lplresearch.com/2020/08/03/the-clock-starts-today-on-this-historically-accurate-election-winner- indicator/
16. NDR.com 8/19/20