Oct 06, 2020
Stocks advanced strongly in the third quarter, extending the rally from the pandemic-driven lows of late March. While the first phase of this recovery seemed to defy most conventional views at the time, the strength in the third quarter was accompanied by increased investor confidence in corporate performance and economic activity.
No doubt, great uncertainties lie ahead, some of which are addressed below. Nevertheless, the gradual transition to a more favorable outlook has clearly validated the initial recovery in stocks. The implications of an improved outlook, however, raises the bar on what it may take to sustain further gains from here.
Consensus expectations are for a range-bound market amidst the potential for high volatility. While a forecast like this would never be too misaligned with most timeframes, it seems particularly appropriate for the next six months as we move through the election and gauge how the economy is holding together until a vaccine becomes widely available.
The key drivers of today’s market have changed little over the past several months. While the noise level has picked up around the election, the Supreme Court vacancy, and now the President’s health, the most important issue remains monetary and fiscal stimulus. In mid-September, the Federal Reserve announced there would be no interest rate hikes for at least three years. That is an extraordinary commitment for an organization that rarely misses an opportunity to keep its policy options open.
This message removed the uncertainty around this component of Fed policy. It also implies that the informational boost from this policy on the market has played out and it is not likely to provide additional upside. Fed Chairman Powell has acknowledged that low rates are not enough to assure the recovery and he has beseeched Congress to pass another stimulus package.
Expectations of a $1 trillion – $2 trillion dollar stimulus bill have been largely priced into the market. Stocks are reacting daily to news that either points to a delay (possibly until after the election or the New Year) or progress (with talks resuming to approve promptly). While the unemployment rate has declined to 7.9%, job growth has slowed dramatically and total jobs are still down by 10.7 million from February levels.
Statistics that measure hours worked and the shift from full-time to part-time show more weakness than revealed by the headlines. As fiscal aid has moderated, additional job losses appear more likely. The longer restricted activity remains in place, the more likely smaller and mid-size businesses face solvency risk.
The persistence and unpredictability of COVID-19 has tempered earlier recovery expectations. The decline in mortality rates has been steady, but trends in reported cases show periodic surges across all parts of the country, keeping the resumption of activities under constant scrutiny. With the change in seasons upon us, the outlook seems even more tenuous.
The vaccine development process has reached a critical stage for 11 companies in Phase 3 efficacy trials. Markets have generally assumed that several vaccines now in production will be approved by year-end with initial limited access expanding more broadly by late spring or early summer. Any significant delay to this timeframe would obviously be a setback to the market. There is also a growing acceptance that even after a vaccine becomes available, it will be a long time before the overhang of COVID is lifted from our daily lives.
Regarding the election, there is more complexity than usual in applying previously useful indicators to predict an outcome. It is also less clear that the market’s reaction to the outcome will follow the normal playbook, making it even more difficult to know how to be optimally positioned.
What is clear is an additional layer of concern around a delayed or contested outcome. One measure of this perceived risk is in the high cost of hedging strategies through year-end to protect investors from a market decline. We do not know if the Presidential outcome will be determined by the Supreme Court, but we do know that human behavior is prone to focus on worst-case scenarios when uncertainties are high. Most of the time, reality turns out better than feared.
Return opportunities from here
Third quarter earnings reports would ordinarily take center stage at this time. Given the recent trend of earnings “beats” and raised guidance over reduced analyst expectations, this earnings cycle would be a catalyst to add to existing gains. Instead, good earnings news might get crowded out by other issues, but they will be important in setting expectations for 2021.
Either way, overall equity returns look challenged at these higher multiple levels. Stocks have had an extraordinary run over the past 11 years, benefitting from specific catalysts that may not be replicable. Some of these include companies supporting their own stock by buying back shares in record numbers, low inflation, tax cuts, margin expansion helped by lower wages, and multiple expansion (stocks selling for higher valuations).
Monetary support from the Fed and low interest rates look to remain in place for the foreseeable future. Those conditions can sustain a healthy stock market, especially when other investment opportunities remain less attractive.
On the other hand, it is harder to see additional rate cuts and new monetary initiatives as the catalyst for additional gains. Corporate stock buybacks may be unable to maintain the pace of recent years due to political pressures to limit this use of their capital; tax rates are probably at their lows; and margin expansion seems doubtful especially if labor expenses and raw materials begin to reflect nascent inflationary pressures. Moreover, while today’s high equity valuation levels could expand further due to low interest rates, the risk associated with these valuations will also be higher.
Return opportunities from fixed income are more straightforward since most bond returns are mathematically derived. The decline of interest rates this year will actually produce good total returns for most bonds in 2020. Going forward, this helpful math runs out, as there is little room for rates to move lower. While some believe that U.S. rates could follow Europe and other countries into negative territory, so far the Fed has dismissed this possibility.
If interest rates simply stay at current levels, the yield on taxable and tax-exempt bonds for good quality, intermediate maturities looks to be in the range of 0.40% to 1.5%. Any uptick in yields will negate these meager returns. In addition, most money markets are paying close to zero today. The fixed income side of a balanced portfolio will continue to provide safety and protection from equity volatility, but until interest rates reset at meaningfully higher levels, bonds are positioned to contribute little to a portfolio’s total return.
Given the myriad of knee-jerk reactions and mid-course corrections that could evolve over the next six to 12 months, our inclination is to ride through the short-term noise. Our focus will primarily be on individual companies and potential industry/sector beneficiaries rather than tactical moves between stocks and bonds.
We think there is merit in value and cyclically oriented stocks performing better in a post-vaccine world, especially as pent-up demand works its way through the economy. Beyond that, we expect that the economy will revert to a slow-growth environment, especially given the enormous debt overhang that will inevitably divert resources from future growth. This backdrop should again favor secular growth stocks.
Our multi-factor approach includes a weighting to valuation for all strategies. This will often keep us from owning momentum driven names that do not have the fundamental support we look for. In our Growth strategy, we have been able to own many of the large-cap tech names that have led the market (Apple, Amazon, and Microsoft), but there are other richly valued performers that have been outside our reach (Tesla, Netflix, and PayPal).
On the non-momentum side, the Growth strategy has good representation to the semiconductor space, companies that serve as the backbone for the broad advancement of technology. Examples include Micron, KLA Corporation, and Lam Research. These companies have very attractive earnings growth opportunities in a recovering semiconductor growth cycle.
Near term, we believe the passing of a stimulus package would be a strong boost to sentiment, but it is still at the mercy of deep political divisions that have been difficult to overcome. Election uncertainty will inevitably end and a vaccine should be approved as safe and effective by year-end. The holiday season will feel different, but could very well come in better than expected. Few will regret seeing 2020 come to an end. Stocks will welcome the natural optimism that comes with a new year, especially 2021.