This has been a year full of firsts for all of us. It was the first time that all 50 states in the United States declared a state of emergency. As COVID-19 spread through our country, we had over 300 million citizens sheltering in place. We had unemployment hit levels we have not seen since the Great Depression. The S&P 500 dropped more than 30% at the fastest pace ever. In the face of a growing pandemic, the S&P 500 has rallied and is only down a scant -3.1% (see the chart below) through the first half of the year. In this Polaris Perspective, we will review what the markets have done during the 1st half of this year, and we will give you our outlook for the 2nd half of 2020.
Just the Facts
The market recovery that we have seen has not been across all sectors. In fact, only three sectors are up for the year, led by the technology and consumer discretionary sectors, which were up 15% and 7.2% for the year, respectively. This is very unusual, as both of these sectors have done very poorly during previous recessions.
And as you can see from the table below, investors continue to favor companies that are showing rapid earnings growth, as opposed to companies that reward their investors by sharing their profits in the form of a dividend. Historically, dividend-paying companies have dramatically outperformed growth companies, with less risk. There is more than a 25% difference in performance between Large-Growth, compared to Large-Value. It’s one of the widest variances I’ve seen in my entire career. We often talk about reversion to the mean. Value (where we invest) will come back into favor, as it has outperformed growth stocks more than 50% of the time.
To further illustrate the same point, the NASDAQ 100 has outperformed the S&P 500 at levels we have not seen since the dot com bubble in 1999. And that’s saying a lot since Apple, Microsoft, Amazon, Google, and Facebook now represent almost 25% of the S&P 500. Imagine the additional outperformance if you back out those five names.
An Irrational Market
I’ve had many clients call me and ask what is making it go up. I try to remind them that we use four pillars to investing (see below). But based upon what is going on in the current market, you can throw two of them out. If you were basing your investment decisions on macroeconomics or fundamental analysis, you wouldn’t be invested at all.
- Technical Analysis – Identify key market indicators to predict market strength and momentum
Macroeconomic Analysis – Understand how the overall economy affects the capital markets Fundamental Analysis – Analyze earnings potential and growth prospects to determine intrinsic valuations
- Market Sentiment – Evaluate the overall investor sentiment to gauge current risk tolerance among different asset classes
We have reviewed the Chicago Fed National Activity Index (CFNAI) many times with our client base. The CFNAI is one of the most important economic indicators that Polaris tracks to determine the economic health of our country. The top pane shows the cumulative growth of our economy. The lower and more important pane shows us the monthly growth of our economy. Zero indicates average economic growth. Any reading above the top dashed green line indicates inflation. Any reading below the bottom dashed green line is considered to be recessionary. As you can see from this chart, our economic activity plummeted to levels never seen prior. May’s data gave us a small uptick in economic activity but was still at record lows.
The Index of Leading Economic Indicators (LEI) is another economic indicator that typically shows us when a recession is on the horizon. Our economy was slowly growing prior to the pandemic. No leading economic indicators can predict a pandemic, so this indicator was not helpful to predict the February/March downturn. We are closely monitoring this indicator for signs of economic recovery. This too might be futile if a vaccine is developed.
Although unemployment in the United States has improved, we are still at levels not seen since 1940. Our current unemployment is 11.1%, slightly off of near-term highs of 14.3%. Unemployment has been much harder on those without a college education. Unemployment is only 7.1% for those with a college degree or higher. It more than doubles to 15.3% for workers with a high school education.
The Headline Consumer Price Index barely grew in May, expanding 0.2%, well below its 50-year average of 3.9%. The cost of food did grow at an alarming 4.0% pace. This was all but offset by the massive 18% drop in energy prices.
Q2 2020 earnings are estimated to have dropped -43.8%. If estimates are correct, it will be the largest drop since Q4 2008. Estimates for Q3 & Q4 of 2020 are significantly below where earnings were a year prior. There is a silver lining… Estimates indicate a strong rebound in 2021 & 2022.
Technical Analysis & Market Sentiment
As we’ve discussed in past volumes of Polaris Perspective, there are many catch phrases. The two that we are following right now are “Don’t fight the Fed” and “Don’t fight the tape.”
Don’t Fight the Fed
This phrase simply means that investors should align their investments with the monetary policy of the Federal Reserve. The Fed has made it very clear that it is willing to back all fixed income products, including ETFs, to ensure a liquid debt market. Our government put together the largest stimulus bill in our country’s history ($1.3 trillion) and has shown signs of willingness to provide further stimulus if needed. Government stimulus has historically led to higher stock market values.
Don’t Fight the Tape
This phrase simply means to follow the general trend of the market, regardless of your personal beliefs on why something should or should not be happening. It ties in with another one of my favorites to quote, “The markets can remain irrational longer than you can remain solvent.” Rather than insisting that you are correct and everyone else is wrong, price doesn’t lie. You don’t want to fight the tape. You want to allow the momentum of the market to carry your investments higher.
As you can see from the graph below, the S&P 500’s first quarter of 2020 was the worst quarter since the Great Recession and the second worst quarter in more than 30 years. This was followed up by the best quarter since 1998, with the S&P 500 recovering 19.9% of the losses it had experienced.
In fact, the S&P 500 has had the strongest rolling 100-day performance since 1933. In the face of the highest unemployment since the Great Depression, economic data points that fell through the floor, corporate earnings that were horrible, and a pandemic that is spreading throughout our country with no vaccine in sight, the S&P 500 just posted its best 100-day performance since 1933. Talk about “the markets can be irrational.”
2nd Half 2020 Outlook
I think many of us would love to shut the books on 2020 and put the year in the past. Unfortunately, life doesn’t work that way. We are only halfway through the year, and there is a lot in front of us. There are four major hurdles left in the year, with two of them being earnings seasons. We also have a presidential election in November and the spike in COVID-19 cases, as a lot of states eased their shelter-in-place rules in mid-May.
It’s All About COVID
Unless you’ve been away from a television set the past month, all that anyone can talk about is the spike in COVID-19 cases and the number of people being hospitalized. As of July 7th, the United States has over 3 million cases of COVID, with over 133,000 people who have died. Currently, 33 states are experiencing a rise in COVID cases (graphics below), with states like California, Florida, Texas, Georgia, and North Carolina hitting all-time highs in the past week.
As you can see from the chart to the right, the daily new COVID-19 cases reached a high in early April, and we were seeing numbers of new cases slowly dropping, as we were strictly enforcing phase 1 pandemic protocol. This changed in June, after many states moved into phase 2 of opening up our economy. We are now hitting daily all-time records of Americans catching COVID-19.
It is even more concerning seeing the hospitalization rates spiking, too. Many have said that the increase of COVID-19 cases is due to more testing. While that may be a contributing factor, the easing of many areas’ “shelter-in-place” orders and the complete disregard of social distancing has put us in this situation. There are areas of Texas, Arizona, Florida, Georgia, and California where hospitals are nearing or at capacity. As you can see from the graphics below, 35 states are seeing an increase of hospitalization rates.
One of the most encouraging COVID-19 graphs is the one showing that the number of people dying daily from this coronavirus are at the lowest levels we’ve seen since we peaked in late April. I have discussed this phenomenon with several experts in this field. They have told me that there are many factors. We now have more equipment and protection for our first responders. They are better equipped today than they were a few months ago to help the extremely sick. Another reason they gave was due to the prolonged shelter-in-place and social distancing mandates still in place today. An additional factor is the average age of people getting COVID has dropped dramatically, as people have become more callous about social distancing. This has allowed the death rate to drop even though we have seen a 50% increase in cases from the highs we saw in early and mid-April. All of them warned me that the death rate would go up exponentially if we overwhelm our hospitals a second time. We have seen a slight uptick over the past few days. We will be monitoring this closely, as this could impact everything from school closures, professional sports, offices closing down, unemployment, people’s willingness to spend money, as well as people’s willingness to be out in public.
Impacts of COVID-19
As we’ve already discussed, this pandemic and the closure of significant parts of our economy has had psychological impacts on all of us involved, and it will change many things in our culture going forward.
One such impact was to our country’s savings rate. April saw an all-time high in our savings rate at 32.2%. While May has dropped to 23.2%, it is significantly above our historic 8.8% savings rate. The savings rate is a direct result of average Americans being afraid to spend their money, due to the uncertainty we are all going through. 70% of our GDP is driven by personal consumption. If our citizens continue to hoard their money, our economy will slow even more, and recovery could take years.
We continue to track things like restaurant bookings, hotel occupancy rates, and air travel to gain an understanding of the areas of our economy that have been impacted the most by the coronavirus. As you can see, there has been a recovery in restaurant bookings but nowhere close to where we were prior to the shelter-in-place mandates. Hotels are also beginning to recover much faster than the airlines, as travelers are choosing to drive to their vacation destinations.
We are beginning to see a demographic shift, from the cities into the suburbs. Your 20 and 30 somethings no longer want to be in the city. They see the benefits of being able to have a yard and more space between themselves and their neighbors. We are seeing a significant uptick in home purchases, especially at the lower price points.
Avoid Most Types of Real Estate
Even though rates are back to historically low levels, most types of real estate are under significant pricing pressure. Let me break it down for you:
Industrial Real Estate – during recessions, industrial production decreases. Less industrial production, less need for industrial real estate, prices drop.
Commercial Real Estate – companies are figuring out that they can let their employees work from home, and they will be as productive as they were in the office. A much larger part of our work force will continue to work from home, even after this pandemic is over. Less need for commercial real estate means prices will drop.
Retail Real Estate – brick and mortar real estate has been coming under pressure for years. As people order more and more goods online, retail real estate will come under further pressure. Retail real estate renting to consumer staples companies should do fine.
Multi-Family Real Estate – a.k.a. apartment buildings. The best renters are moving out to buy their first home. The worst renters are now unemployed and can’t pay rent. This is going to be a double whammy to multi-family real estate.
Single-Family Real Estate – this is the only part of the real estate market that I think will do well. Buying pressure on the low end of the market will ripple all the way up to the top. This is a pretty safe bet, especially in suburbs surrounding large metropolitan cities.
We have just experienced a “one of a kind” first half of the year. A worldwide pandemic sent our markets down in a waterfall cascade that we’ve never seen before. It was the fastest 30% drop in the S&P 500’s history. Polaris was decisive in our decisions, which resulted in our clients losing less than half of their benchmark, from peak to trough. While the broader indices like the S&P 500 have recovered,it is as a result of a narrow focus of the large-cap growth companies that have pushed the S&P 500 back up to near break-even levels. The equal weighted S&P 500 was down -12.41% for the first half of the year. The Russell 1000 Value (the universe that we use to select investments for most of our strategies) was down -16.31% for the first half of the year. I am very proud of how well we have performed under unprecedented market conditions.
There are several obstacles that have to be overcome for the markets to continue to rise. The S&P 500 is overvalued, as a result of the top five companies trading at over 36 times their trailing twelve-month earnings. The rest of the S&P 500 (excluding the top 5) is trading at 19.5 times their trailing 12-month earnings. A change of leadership, from large-cap growth to large-cap value is the only way the markets will continue their upward trend. There is also a lot of risk that some of the truly overvalued large-cap growth names might revert to the mean, pulling the index down. This does not mean that our investment strategies will be negatively impacted.
Uncertainty about the election in November will become more and more relevant to the market the closer we come to the election. A close election could add to the volatility in the markets this fall.
The largest obstacle to market growth remains the COVID-19 pandemic. The United States has been hit harder than any country in the world. Perhaps not in cases per million, or deaths per million citizens, but definitely in absolute terms. We have over 3 million cases and 130,000 people dead. We lead the world in these gruesome statistics. We will be watching the statistics even more closely when children go back to school. A large-scale shut down of our K-12 schools would have a major impact on any attempt to open our economy, as parents would be forced to be at home to help take care of their children. I mentioned earlier that work from home will become commonplace, but not all workers have the ability to work from home. It’s pretty hard to manufacture silicon chips or a car from your kitchen table.
As I quoted earlier, “The markets can remain irrational longer than you can remain solvent.” I can’t tell you with any kind of certainty where the markets will be in six months’ time. What I can tell you is we are ever vigilant in monitoring the risks in the market. As tactical investment managers, we will quickly lower the risk in your portfolio if we feel the markets are going to correct again. Otherwise, we will continue to try to squeeze as much return out of this very irrational market as we can.