Third quarter of 2020 ended in a fizzle. September was the S&P 500’s first monthly loss since March, ending a five-month winning streak.
Q3 2020 Update:
Even with September’s 3.80% decline, the S&P 500 still produced an 8.93% return for the quarter (see the chart below).
Third quarter’s strong performance pushed the S&P 500 into positive territory for the year, finishing up at 5.57% YTD. This is an amazing feat given everything going on this year.
Third quarter was anything but usual. We saw a COVID resurgence in Europe, as things began to ease a bit here in the United States. The Black Lives Matter movement was reinvigorated in May, but protests and social unrest has lingered far into the third quarter. And California decided to start its fire season early this year, with over 4.1 million acres of land having burned (and we still have another month or two to go). That’s more land than the entire state of Connecticut. I wish I could say that we could expect fourth quarter of 2020 to calm down but that’s just not realistic. We have an upcoming election in November and children returning to school. It will be very interesting to see how this all works out.
Market Summary:
While the S&P 500 is up for the year, this has been a year of “haves and have nots.” Here are the winners and losers so far this year:
- The NASDAQ is up 24.46%, as technology and biotechnology stocks have dominated the market.
- Gold prices are up 24.19% for the year, while the S&P Goldman Sachs Commodities Index dropped 19.72% during the same period.
- Long-term U.S. treasuries are up 21.35%, as U.S. investors flocked for safety, and foreign investors continue to avoid investing in the $16 trillion of negative yielding bonds worldwide.
- Emerging markets have eked out a 2.67% return (in their own currency). You would have lost all of this return as a U.S. investor, because the dollar has dropped 2.75%.
- Developed international investing was a weak spot, with the EAFE (Europe, Australia, Far East) dropping 9.44% through the third quarter.
- Third quarter was good for most sectors, with only energy showing a loss. The energy sector dropped 19.7% during the quarter, bringing it to a 48.1% loss for the year. Even though the other sectors were up for the quarter, financials, real estate, utilities, and industrials are all under water for the year (-20.2%, -6.8%, -5.7%, & -4.0%).
- Third quarter was led by the consumer discretionary, materials, and industrial sectors, up 15.1%, 13.3%, and 12.5% respectively. Technology, consumer discretionary, and communication services are the top performing sectors for the year, up 28.7%, 23.4%, and 8.6% respectively.
- All nine style boxes were up during the third quarter, but growth continued to outperform value at a level we haven’t seen since the late 90s. Five of the nine style boxes remain negative for the year, with large-cap growth leading the positive performance, up 24.3% for the year. Mid-cap growth is up 13.9%, large-cap blend is up 5.6%, and small-cap growth is up 3.9% for the year.
Current Market Environment
The secular bull market remains intact, even though the United States is in a recession. As we’ve discussed before, a secular bull market is a long-term upward trend in the market. The last one we had was from 1982 through 2000. That secular bull market endured the 1987 stock market crash, the 1990 recession, and the 1994 near recession. The average secular bull market lasts 14 years, with the shortest lasting just 9 years. We began our secular bull market in 2013, giving us reason to believe that the markets will continue to generally trend up for several years to come.
As we’ve already discussed, some sectors have fared far better than other sectors as the markets recovered (see below). The first part of the recovery has been dominated by technology, consumer discretionary, and communication services stocks. Rarely do companies that start a rally during a recovery lead the markets further into new highs. Look for a rotation of leadership.
While sector allocation mattered, so did the style and size of the company. The quarter was dominated by large-cap growth, giving it an even more impressive year-to-date return.
The variance in performance between dividend paying companies (aka – value) and growth companies are at levels we haven’t seen since the late 1990s. Historically, dividend paying companies have outperformed companies that don’t pay a dividend and take less risk in the process. We expect there to be a “reversion to the mean,” meaning at some point in the near future, you will begin seeing value outperforming growth.
As we discussed in our last Polaris Perspectives, the S&P 500 and the Dow Jones Industrial Average are becoming less and less a way of accurately understanding the overall health of the markets. The reason these benchmark indexes are becoming less useful is they
are being dominated by a few companies. The top five companies represent over 22% of the S&P 500 index. We refer to them as the “fab five.” It’s Apple, Amazon, Microsoft, Google, and Facebook. The companies are collectively up over 40% for the year, whereas the S&P 500 “equal weighted” index is down 4.75% through September 30th. The top 10 companies are almost 30% of the S&P 500’s weighting. These are levels we haven’t seen since the early 80s. Keep a watchful eye, for the S&P 500’s performance will live and die by these
10 companies.
Even though we had a substantial drop in corporate earnings, things look to have stabilized. Second quarter earnings (reported in third quarter), topped revised down estimates, easing investors’ nerves. Estimates of future corporate earnings look promising going into 2021.
From a historical standpoint, the S&P 500 looks expensive is simply looking at the forward P/E ratio. There are many ways of evaluating the valuation of the market. Given our zero-interest rate environment and the current yield curve of U.S. treasuries, our markets aren’t as overvalued as this chart may appear.
As we’ve discussed, growth has significantly outperformed value and in doing so has become far more expensive than value from historical perspectives.
All eleven sectors of the S&P 500 have been impacted by COVID-19 and our shelter-in-place / work from home economy. This has also forced companies to rethink their dividend policy. As you can see from the graph to the left, even with our pandemic, most companies have been able to keep or increase the dividend they pay to their shareholders.
We experienced the largest one quarter drop in the history of our economy. Our real GDP has declined over 10% since March
(see below). To put this into perspective, our economy shrunk by 4% during the Great Recession. We haven’t seen this kind of decline since the demobilization of military operations after World War II. The Great Depression lasted four years and declined a total of 26.7%. That’s an average of a little over 6 1⁄2% per year. We dropped 10% in less than six months!
Our deficit to GDP is at 15% (the middle band of the chart below), a level that we haven’t seen since World War II. This statistic will most likely get worse before it gets better, as further stimulus appears to be needed in order to continue to stabilize our economy and the stock markets.
We have seen a steady improvement in many economic data points. Unemployment (below) has dropped from a high of over 14% down to 8.4%. While this is above our historical unemployment rate of 6.3% and dramatically off of our 3% pre-COVID economy, the trend is improving quickly.
We are also continuing to see upward trends in air travel, hotel occupancy, and seated restaurant dining (see below). Continued demographic trends show people moving out of major cities and into the suburbs. This has led to increased housing prices,
an increase in used car values, and increases the probability that the way people work will have been irreversibly changed.
Fed Reserve dropped rates to zero percent early into the pandemic. As you can see from the chart below, we were a zero-interest rate environment from late 2008 until fall of 2014. We expect to remain in a zero-interest rate environment through 2021. There isn’t much visibility beyond 2021, but I would expect rates to remain historically low for years to come.
And the Fed has made it clear that they will be leaving fed fund rates at zero percent for a long time to come. As you
can see from the chart to the right, fed fund futures indicate
a 100% probability that rates will remain at zero percent through September of 2021 (as far out as fed fund futures go).
September 22, 2021 Target Rate
Historical Fed Fund Rates
Real yields on the 10-year treasury have gone negative, making most bond investing unappealing at best. While the 10-year treasury is yielding 0.69% as of September 30th, you lose all of your return due to our current 1.73% inflation. If you bought a 10-year treasury on September 30th, you would have locked in a real return of -1.04% per year for the next 10 years.
The Rest of the Year
Our markets have been completely driven by the pandemic that has turned all of our lives upside down. As I write this update, there are now more than 35 million confirmed cases worldwide, with more than 1 million people who have succumbed to this deadly virus. The United States still leads the world in cases (7.6 million) and deaths (over 214,000).
Daily new cases have improved significantly from our July highs. The United States is still experiencing high levels of spread in many parts of the country. Approximately 35,000 people are getting COVID every day in the United States.
The daily death rate also continues to improve. We are not at our best levels since the pandemic began, but the overall trend shows signs of continued improvement. Our waning death rate can be attributed to a few things: 1) younger people getting COVID at a higher percentage, 2) improved knowledge on how to care for someone who has COVID, 3) improved number of ICU beds and equipment.
We are cautiously watching all of these data points as children begin returning to school. I’m sure you have read or heard stories about students at college and what they are experiencing. Any good that is coming out of returning children to school will surely be tested with the onset of winter.
There are many companies that are conducting test trials on COVID patients. Unfortunately, there is not a vaccine available today nor does there appear to be one in the near future. When there is a vaccine, how effective will it be? If it is rushed to market, what are the unintended side effects? Once a vaccine is created, we will need to inoculate 70-80% of our population to create a herd immunity. That’s 250 million people in the U.S. alone that will have to get a shot. It’s not an insurmountable number, but it will take a while. Only after this happens do I see life returning to anything like it was prior to this pandemic. In other words, we are going to be in this mess a lot longer than most people are claiming.
The Election
Every four years, I am asked the same question. How will the Presidential election impact us and our portfolio? I will answer the question, but I am going to start by reminding you that we manage money for over 1,000 households who live in 46 of the 50 states. As you can imagine, our clients’ political beliefs fall throughout the full spectrum of ideology. In order to manage your money effectively, I must be agnostic when it comes to politics. So please don’t read into what I’m about to write. I’m just going to state the facts. They aren’t my opinion, nor are they from a red or a blue (or even purple) point of view.
Historically, an election year is a little more volatile than most years. If you look to the chart below, you will see that the first year of a president’s four-year term, the markets have the worst performance. The second year isn’t much better. It isn’t until the third and fourth years that the markets have historically performed.
Markets don’t like uncertainty. The chart below shows how the markets have acted historically when the incumbent party wins or loses the Presidential election. Keep in mind that even though this chart goes back to 1900, there have only been 30 elections during this span. If you read this chart closely, you’ll see that it says incumbent party, not the incumbent President wins or loses. In other words, this chart is more about a political party remaining in power rather than the same President remaining in power. I went back and looked at the election results of all 30 elections. There were ten times that the incumbent Republican Party retained power and won the Presidential election. There were six times that the incumbent Republican Party lost the election. This isn’t a large enough sample size to rely on for your investment decisions. That said, the markets historically rallied when the incumbent Republican Party retained control of the Presidential office. The six times they were unable to retain control, the markets dropped but dropped before the election. They then traded sideways with a “lame duck” President in office.
The current polls show Joe Biden with an 8 point lead over our current President, Donald Trump. An equally significant statistic is Biden has kept a fairly significant lead over Trump since May. The chart below was created by five thirty-eight.
As we all know far too well, you can’t really rely on polling to perfectly predict an election. Just look at the five thirty-eight’s predictions of the 2016 election between Clinton and Trump. They totally got it wrong. The 2020 election is going to come down to a few swing states and who shows up to vote in those states.
The markets will react negatively if either party tries to challenge the election results in court. Go back and look at how the markets reacted when Al Gore requested a recount in Florida. Do you remember the “hanging chad?” This could be much worse.
Historically, the markets have performed best when there is a balance in power. The best performing markets are when there is a Democrat as President and a Republican controlled Congress. The next best performing market is when there is a Republican President, with a Democrat controlled Congress. The worse performing markets are when one party controls the Presidency and Congress. Stay tuned, for the next month is going to be interesting.
We don’t pretend to know who is going to win the election. We don’t try to predict the elections of Presidents, U.S. Senators, or members of the House of Representatives. What we do is put together “if, then” scenarios and what changes we would make to the strategies that make up your portfolio. If Donald Trump wins the election but the Republican Party loses control of the Senate and the House, then we should make X changes to our portfolios. If Biden wins the election but the Republican Party retains control of the Senate, then we should make X changes to our portfolios. We try to map out the scenarios and the most likely outcome as a result of these scenarios, so we aren’t “reacting” to the market; we are being strategic.
My best advice from here… Take a deep breath (while wearing a mask). We’ve all been through a lot this year, and unfortunately, we will be going through even more before the year is through. Be assured that Polaris Wealth is actively monitoring the risk in the market, and we will act decisively to protect and grow your portfolio.
