What a difference one quarter makes. As we wrote the last quarterly newsletter in April, the S&P 500 had just completed a -34% drawdown, the bond market was in disarray, and a good chunk of the economy was shut down due to Covid-19 concerns. Fast forward to this quarter which saw a dramatic reversal in financial markets. The Dow Jones Industrial Average (DJIA) recorded its best quarter since 1987. The S&P 500 had its best quarter since 1998. And the NASDAQ had its best quarter since 1999. In the following chart, Bespoke highlights how a number of other asset classes did during the month of June, Q2, and the first half of 2020.
These gains came in spite of weak economic data and earnings expectations. So, what gives? Markets tend to be forward looking and discount future events. Just as the market was forward looking on the way down (in February/March) in response to Covid-19 concerns, it tends to be forward looking to a recovery. In addition, liquidity from the Federal Reserve, and fiscal stimulus (i.e., The Cares Act) from Congress, were driving factors. Speaking more to the former, unprecedented asset purchases and Balance Sheet expansion by the Federal Reserve helped to put a floor under the S&P in late March and fuel the rally off the lows as indicated by the following chart from Bloomberg.
Aside from the liquidity factor, we have seen continued improvement in economic data which suggests that the worst of the crisis may be behind us; however, we would caution that the road to recovery likely remains slow and uncertain. One area that we’ve seen improvement in is the labor market. As the economy began to quickly shut down in mid-March, jobless claims spiked to levels unmatched in any prior recession. As the following chart from Merk Investments indicates, jobless claims in early April were over 5 million per week but are trending lower, as are continuing jobless claims which would suggest that the worst for the labor market and job losses may be over.
We’re also seeing encouraging news in the latest nonfarm payroll reports. For example, the June jobs report signaled +4.8 million job gains with headline (U-3) unemployment falling to 11.1%. (Bureau of Labor Statistics: https://www.bls.gov/news.release/pdf/empsit.pdf)
Shifting gears, the Federal Reserve (Fed) was arguably the biggest driver of gains in both the equity and fixed income markets in Q2. As JPMorgan notes in the following chart, the Fed went on an unprecedented asset purchase binge that dwarfed prior rounds of quantitative easing. In fact, the Fed has increased its Balance Sheet by $2.9 trillion since March 23rd to a figure just north of $7 trillion. These purchases helped add liquidity, stability, and confidence to reverse the negative sentiment from Q1 brought about by swift asset price declines and high volatility. The old adage of ‘don’t fight the Fed’ was on full display since markets bottomed in late March and have rebounded sharply since.
- The Q2 earnings season will come into focus shortly. Expectations are low and understandably so given the amount of uncertainty in the current environment. Factset is projecting earnings to decline by -43.8% Y/Y with revenue falling by -11.1% Y/Y. (Factset Earnings Insight) https://www.factset.com/hubfs/Resources%20Section/Research%20Desk/Earnings%20Insight/EarningsInsight_070220.pdf
Reasons for Optimism:
- Continued support from the Federal Reserve & Congress.
- Economic data continues to broadly improve and the economy is steadily bringing back jobs as indicated by the May and June Nonfarm Payroll Reports (Bureau of Labor Statistics).
- Potential upside surprises in earnings for Q2. With expectations low and difficult to gauge, better than expected results and quarterly guidance could be a positive catalyst.
- A Covid-19 vaccine is being aggressively pursued by a number of biotechnology companies and the successful development of one would be a huge win for the economy and financial markets.
- Large quarterly gains like we saw in Q2 tend to carry over to the following quarters as the following chart from LPL Research illustrates.
- Political risk. In general, election years tend to result in market uncertainty.
- Elevated valuations. Traditional valuation metrics to gauge the S&P 500 like Market Cap to GDP and Price to Sales are near record highs. While elevated valuations do not necessarily signal a decline and can be poor timing indicators, they can suggest lower future returns.
- Rising risk of inflation. Unprecedented stimulus measures from the Fed and Congress have resulted in significant additions to the national debt and Federal Reserve Balance Sheet. Such policies may result in higher inflation.
- Potential reduction in stimulus or Fed intervention. Just as the markets have largely rallied on stimulus, a potential reduction in stimulus is a market risk.
- Potential second wave of Covid-19. As the following infographic from The Covid Tracking Project notes, the number of cases and hospitalizations are rising in lockstep with increased testing; however, deaths appear to be on the decline.
- In closing we’d like to leave you with this chart from The Irrelevant Investor which depicts reasons to sell since the financial crisis low (March 2009) overlaid with the market’s (S&P 500) response. Over time, history has tended to reward disciplined investors who stick to a plan and do not panic.
As always, feel free to reach out to us if you have any questions or concerns.
This commentary is provided for general informational purposes only and should not be construed as personalized financial or investment advice. Information has been obtained from sources deemed reliable but is not guaranteed. Securities and investing involve the risk of loss. No strategy can assure a gain or the avoidance of loss. Any comparative indices shown are unmanaged and are provided as an indication of the performance of a given segment of the capital markets. Indices cannot be invested in directly, and the returns shown do not reflect any fees, costs, or expenses. Past performance should not be relied upon as an indicator of future performance. Forward looking comments necessarily involve known and unknown risks and are subject to change. There can be no assurance that forward-looking statements will prove to be accurate, as future events could differ materially from those anticipated. We undertake no obligation to update forward-looking statements if circumstances or opinions should change.