1. How do we make sense of the disconnect between the disastrous economic data and near-record high US stock indices?
Markets are forward-looking mechanisms. The near-40% decline in the S&P 500 Index from February 19th to March 23rd was the market pricing in the ruinous economic data being released in recent weeks, and potentially more still yet to be released.1 As a result, lagging economic indicators, such as gross domestic product and the unemployment rate, will likely be of little future consequence to the market. Instead, markets are trading, and will likely continue to trade, not on whether conditions are good or bad, but rather on whether circumstances are getting better or worse. There is little that is “good” about the current environment, but conditions have improved markedly since the March 23 bottom. Fiscal and monetary policy have been effectively implemented on a global scale, the fears of the pandemic have receded with case loads and hospitalizations down meaningfully in many of the hardest hit areas (Milan, New York for example)2, human mobility is picking up,3 and economic activity is noticeably rebounding.
2. The market is now priced for perfection. Wouldn’t it make sense to sell the rally?
If investors have learned anything over the past three months, it should be about the folly of trying to time markets. Case in point, money market assets at the beginning of March were $3.6 trillion and currently stand at a record $4.8 trillion.4 The challenge of derisking portfolios is knowing when to reenter the market. The 40% rally in the S&P 500 Index since March 23 is proof of that.5 Waiting for exceptional economic data has historically been a mistake. Markets in the years following the global financial crisis, for example, had already staged a sizeable rally by the time that mortgage default rates peaked, household balance sheet deleveraging concluded, and weekly jobless claims returned to average.
It is true that there are still many challenges ahead and policymakers need to effectively bat four for four with regards to getting monetary policy, fiscal policy, re-opening policy, and trade policy right. A dreaded second wave of COVID-19 cases could be in the offing, potentially creating renewed volatility in markets. However, markets will likely be focusing attention on the long-term prospects of a very slow and prolonged recovery supported by massive policy support and a protracted period of low interest rates, all of which should ultimately be supportive of equity and credit markets. Being structurally short equity markets here is akin to betting against policymakers, human ingenuity, science and medicine.
3. Aren’t equity valuations too elevated to begin rerisking portfolios now?
Historically, valuations have been very poor timing tools, having little to no statistical impact on short- to intermediate-term returns.6 Equity multiples tend to rise in market recoveries as the market prices in a forthcoming recovery in economic activity and earnings growth. Finally, stocks continued to trade cheap to most other asset classes, including US government-related securities and investment-grade corporate bonds.7
4. Isn’t this all inflationary?
That’s the idea. The demand destruction resulting from the COVID-19 outbreak and the subsequent shutting down of large segments of the economy have unleashed deflationary forces on the global economy. Deflation is the worst of all outcomes as consumers and investors put off consumption and investing expecting prices to fall more in the future. The US Federal Reserve, per its dual mandates of maintaining price stability and full employment, has responded aggressively to reflate the economy and asset prices. The Fed’s actions are proving successful (note the recent decline in the US dollar and the rise in commodity prices8) but are unlikely to unleash massive inflationary pressures on the US economy. Structural forces against inflation, including an aging population globally, remain and will now be compounded by a protracted period of elevated unemployment globally.
5. Has the much-anticipated rotation from growth stocks to value stocks finally commenced?
A more accurate assessment than a rotation would be a widening of the breadth of the market (currently more than 95% of the companies in the S&P 500 Index are trading above their 50-day moving average9). Value stocks finally started to participate in recent weeks, even as growth stocks outperformed in the month of May.10
For value to outperform growth, there needs to be a catalyst. Successful reopening of large segments of the economy and subsequent improvements in economic activity would likely be that catalyst. Sectors and industries such as financials, energy, hotels, and airlines would be likely beneficiaries. If instead we emerge from the pandemic in inconsistent and irregular intervals, then it is likely to be an environment that continues to favor true growth companies.
1 Sources: Bloomberg, Standard & Poor’s
2 Source: Johns Hopkins, 6/3/2020
3 Source: Apple, Inc. 6/3/2020, as represented by the Apple Mobility Index
4: Source: Investment Company Institute, 5/27/2020
5 Sources: Bloomberg, Standard & Poor’s, 6/3/2020
6 Sources: Bloomberg, Invesco. Analysis compared the statistical correlation between equity valuations and subjective returns over one, three, and five years.
7 Sources: Bloomberg, Invesco. Analysis compares the earnings yield of the S&P 500 Index to the 10-year US Treasury rate and the yield of the Bloomberg Barclays US Corporate Bond Index
8 Source: Bloomberg, 6/3/2020. As represented by the US Dollar Index Spot Rate (DXY), copper prices and US Crude Oil Texas West Intermediate Cushing, Oklahoma spot price.
9 Source: Strategas Research Partners, 6/3/2020
10 Sources: Bloomberg, Standard & Poor’s, 6/3/2020. Analysis compares the returns of the S&P 500 Growth Index and the S&P 500 Value Index.
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The Bloomberg Barclays US Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD-denominated securities publicly issued by US and non-US industrial, utility and financial issuers.
The S&P 500 Index is a stock market index that measures the stock performance of 500 large companies listed on stock exchanges in the United States.
The S&P 500 Pure Growth index is a style-concentrated index designed to track the performance of stocks that exhibit the strongest growth characteristics by using a style-attractiveness-weighting scheme.
The S&P 500® Pure Value index is a style-concentrated index designed to track the performance of stocks that exhibit the strongest value characteristics by using a style-attractiveness-weighting scheme.
The US Dollar Index (USDX) is a measure of the value of the US dollar relative to the value of a basket of currencies of the majority of the United States’ most significant trading partners.
US West Texas Intermediate (WTI) is the main oil benchmark for North America as it is sourced from the United States, primarily from the Permian Basin. The oil comes mainly from Texas. It then travels through pipelines where it is refined in the Midwest and the Gulf of Mexico. The main delivery and price settlement point for WTI is Cushing, Oklahoma.
It is not possible to invest directly in an index. Past performance is no guarantee of future results.
Growth stocks tend to be more sensitive to changes in their earnings and can be more volatile.
A value investing style subjects the fund to the risk that the valuations never improve or that the returns on value equity securities are less than returns on other styles of investing or the overall stock market.
All investing involves risk, including risk of loss.
Investments concentrated in a relatively narrow segment of the economy may be more volatile than nonconcentrated investments.
The opinions referenced above are those of the authors as of June 11, 2020. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.