Nauset Wealth Managment
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Category: Market Update

Nauset Market Commentary – Q2’2020

Market Performance Recap: Historic Stock Bounce Back

The Russell 1000 notched its best quarterly performance in 21 years, rising +21.8% in a strong bounce back from the pandemic-induced market decline in the first quarter of the year. While the Covid-19 pandemic continues to hinder economies across the globe, the strong rally puts the US large cap Russell 1000 index down only -2.8% for 2020. The surprising Q2 rally was led by technology, consumer discretionary and communications stock sectors. US small cap stocks posted an even stronger rally of +25.4%, but remain off -12.8% year-to-date. For international stocks, the MSCI EAFE developed country index gained +14.9% for Q2, now down -11.3% for 2020, while the emerging market index rebounded +18.1% in the quarter and is -9.8% year-to-date. Barclays Intermediate Gov’t/Credit bond index posted another solid quarter with a +2.8% increase.

Economic & Market Discussion: Making Sense of the Market Rally

As US equity markets posted their best quarter in over 20 years, the US economy has struggled through its worst quarter on record. How and why did this happen? And what does it mean for markets going forward?

  • Economic Rebound – Broadly speaking, the market is reacting to better-than-expected economic data as shown in the graphs below and a reversal in unemployment data in May and June. Despite the current surge in Covid-19 cases in many states, the market is supported by the likelihood that there will not be a second nationwide economic shutdown. Also aiding the market upswing is investor optimism regarding vaccine development. While the market may have reacted too strongly and quickly to the positive economic trends, the rebound is underway. Given the strong Q2 stock gains, the market’s reaction to future good economic news may be muted, while any setbacks in the economic rebound would be negative.

  • Don’t Fight the Fed – The Fed has stepped up in a huge way to support the economy by ensuring the mechanics of the credit market and purchasing bonds across several markets. The Fed has also committed to low interest rates for several years. As with positive economic data, the markets have reacted very strongly to the Fed’s easy money policies. In the short term, we expect the Fed to continue to act as a backstop to the bond markets and lessen the negative effects of the pandemic on the economy.

  • Winner, Winner – Another key to understanding the exceptional stock market gains in Q2 is that the largest US public companies, especially tech firms, have been hurt less by the effects of the pandemic than smaller and private businesses. Thus, the earnings of many US large cap public companies should outperform GDP despite the impact of lower aggregate demand. Additionally, accelerating structural changes in the economy caused by the virus are also likely to benefit the mega-cap US public companies.

While the rationale for a stock market rebound is understandable, the speed and strength of the rally may have anticipated a faster economic recovery than what is unfolding. For that reason, we are cautious with respect to further gains in 2020, and markets are likely to experience more volatility as small businesses and schools reopen this quarter. There are plenty of factors to monitor in the coming months. In addition to the usual economic and market data, we are also watching Covid-19 vaccine progress, the Presidential race and social injustice protests. Any of these elements could have positive or negative market impact over the next quarter as the recovery continues.

Portfolio Strategy: Maintaining Balance

Anticipating a V-shaped economic recovery, the US stock market is now fully or slightly overvalued. Keeping with our usual long-term perspective, here is how we managing portfolios entering the second half of 2020.

  • Near Neutral – The market rally and recent rebalancing have placed most portfolios at or near neutral allocations for equities. We expect to maintain that stance unless market conditions drive market levels significantly in either direction, in which case we would likely rebalance back to neutral.
  • Stay with Strength – As a form of defense, we will continue to focus on quality in both stocks and income-producing securities during this period of market uncertainty. We will favor investments with a margin of safety, such as investment grade bond funds, and large cap US tech and health care stocks. 
  • Open to New Opportunities – As the economy continues its recovery amid the uncertainty, we will search for attractive opportunities in credit as well as international and smaller cap stock areas based on valuation.

Coronavirus – Market Impact

After mostly ignoring the potential impact of the coronavirus that originated in China, US markets have suffered a sharp sell-off, as the S&P 500 Index is currently about -8% off its recent all-time high. The fear is the virus may spread more broadly than originally predicted and negatively affect economic activity around the globe.  

This COVID-19 viral outbreak is a very real headwind to economic growth in China, globally, and the US. The extent of the eventual damage is difficult to predict, but it will temporarily lower GDP growth across the globe. The good news for the US is that, while there will be some impact due to disrupted supply chains and reduced exports, the US economy has a solid foundation of low unemployment, improving wage growth and is much less dependent on the rest of the world than most countries.

How bad will the impact be? How much further will the markets decline? Both answers are unknowable at this point. However, we can say the following – until the global outbreak is successfully contained, markets will trade on fear and hope, not on fundamentals of growth and profit. And that will lead to continued volatility.

Nauset’s portfolio strategy has prepared us for this type of volatility with an allocation to securities that provide market buffers. Additionally, our long-term financial planning focus takes into account and anticipates market declines. As long-term investors, we don’t want to make the mistake of trying to call a short-term market bottom or time the market. 

If you’d like to read more about the coronavirus impact, the Independent Market Observer’s article, How Should Investors React to the Coronavirus?, is an excellent piece. 

Nauset Market & Strategy Update

Key takeaways regarding recent market activity:

  • The market’s old companion volatility is back and likely with us in 2018
  • Rising rates and inflation concerns will continue to be a key concern for all stock markets
  • Despite solid US and global economic fundamentals, potential for market gains are lower than in 2017
  • Our approach is to stay diversified and rebalance as opportunities occur

What Happened: Welcome Back Volatility

A market correction can be unsettling but it’s important to remember it is normal. We haven’t seen one in a while as we have been in an unprecedented period of low volatility. The market sell-off of the past week was swift and appeared just days after a new market high. The S&P 500 stock index hit a new all-time high of 2873 on January 26. Thirteen days later on February 8, the S&P 500 was down -10.2% from that high, mostly from losses in the past five trading sessions. To put this into perspective, the S&P 500 is down -3.5% for 2018 due to the spike up in the first three weeks of the year.

The reason for the sell-off: rising interest rates on the 10-year Treasury bond along with a whiff of wage inflation from the Feb 2 jobs report got the attention of stock investors. Higher rates are generally negative for equities, especially after the prolonged period of historically low rates. The 10-year Treasury yield moved up from 2.4% at the end of 2017 to 2.8% in early February. And when coupled with a forward P/E ratio on S&P 500 stocks at the upper end of its historic range, investors got nervous. Add to this mix, the intention of the Fed to push up short-term rates at least 3 times this year, and the stage was set for a sell-off. The sell-off itself was likely amplified by short-term trading programs and hedging activity, which often dominate daily trading.

The irony of the situation is that S&P 500 earnings have been excellent this quarter and are projected to continue to be strong in the near term. And that is usually positive for stocks. We believe that the positive economic environment will likely limit the decline in equities. However, the bottom line is that rising rates will likely make it difficult for markets to move up in 2018 as the current US economic cycle, now almost nine years old, may finally be in its late stage.

Going Forward: Why Stay Invested?

So, what happens now? The economic backdrop continues to be positive, which will support markets. While growth is almost always a good occurrence, too much growth and earnings momentum can cause inflation to rise, which above a certain level is problematic. Some analysts believe the recent cut in corporate tax rates may push the economy toward an overheating phase. We are not in full agreement with this view, as the impact of tax reform on both consumers and corporations is still unclear. However, if inflation does rise, the Fed would address it by raising rates more quickly, which in turn would push up interest rates in general. And that scenario would likely be negative for stocks.

Under almost all scenarios, we do see rates and inflation rising. The concern for the markets is how much and how quickly. Right now, the bond market is expecting the Fed to tighten 2-3 times this year, up from lower assumptions only six months ago. That means that the bond market’s expectations are much closer to the Fed’s projected tightening path. Which, in turn, suggests that the 10-year yield may now be closer to “fair value” than it has been, and interest rates may settle in the current range and perhaps move slowly to the upside. As such, we will keep a close eye on both inflation and rates.

Even with rate and inflation concerns, the solid economy and earnings picture does provide a way forward that may result in gains for stocks this year. It just won’t be the smooth ride of 2017. Whether the market settles down from here or continues to exhibit high volatility is not knowable. Our view is that it will stay choppy for a while. The recent whipsaw is a reminder that volatility and pullbacks are the price we pay for the excellent returns that stocks can produce over the long run.

The chart below shows that sizeable sell-offs and pullbacks are normal even in years where the market is positive.

 

Finally, let’s put some context around the current market sell-off. The US stock market has had a strong run over the past 15 months without even a -10% market pullback. As a result, the S&P 500 was up over +30% in that period. Corrections of -10% are normal and happen about every 2-3 years, so it is no surprise that one would occur now. Over the past 50 years corrections, defined as a -10% to -20% price drop from the peak level of the market, have averaged about -14% and bottomed in about five months.

While we can’t predict what will eventually happen, this provides some context. At worst, a bear market, defined as a drop of -20%+ in the broad index, could develop from this correction. We put a low probability on that occurring given the US economy is on solid footing and not showing any signs of a recession, which usually accompanies a bear market. In summary, a correction is normal, and for long-term investors who stay the course, it’s often a healthy development that can help markets consolidate and eventually move higher.

Current Investment Strategy: Keeping Our Balance

As we have noted at volatile times in the past, we at Nauset are long-term investors, not traders, so our mantra is to stay balanced, diversified and disciplined. Our advantage is that we are long-term investors and we can handle short-term volatility as we manage positions for the long-term. 

We build clients’ portfolios for the long run and to fit clients’ financial plans. As part of that approach, we weather market corrections like the current sell-off, and as conditions evolve, we adjust to new market realities. While a market correction may be unsettling, we have a bias to action around the following three areas:

  1. Rebalancing – we continuously monitor our clients’ portfolios and will take steps to rebalance to specific client asset allocation target ranges and risk profiles. 
  2. Tax-loss harvesting – With the recent sell-off, recently purchased positions may be in a loss position. We may sell these positions from taxable accounts to create a capital loss and buy back the same security 31 days later, or buy a similar security, to replace it in the allocation. This will provide clients with a tax offset for a portion of earned income or gains we take in the future.
  3. Opportunistic buying – Volatility and sell-offs often create price distortions and thus opportunities in individual securities, subsectors or sectors. We are monitoring the market for the opportunity to add to areas that we find attractive, such as cyclical and growth stocks in tech, financials and consumer discretionary sectors.

Waiting for Godot?

The chorus of investment pundits calling for an end to the current US stock rally has grown larger and louder and yet, the market continues higher. Let’s examine why a correction will happen, why predicting it is hard (and potentially hazardous to your portfolio) and how we think about it.

Corrections have a strong track record of showing up (unlike Godot), as part of a normal market. A correction is commonly defined as a -10% decline. The average intra-year decline is historically -14%. Even in positive years, it is unusual not to experience a mid-to-high single digit decline. (See chart).

We have been waiting for a correction (like Godot), but not for very long. The last S&P 500 correction began in the summer 2015 and hit its low for the year in October. The drop happened to be a decline of about -12%. From November 2015 until February 2016 the market again took a double-digit dive. Since then the market has climbed +33% with fresh highs being set on July 12, experiencing one measly -6% drop along the way.

Based on history we expect a correction to occur before the end of the year. However, timing and duration are elusive and we are not trying to predict it. A correction may be triggered by almost any event – Fed Reserve action, oil prices, a poor jobs report, or a geopolitical incident. Rather than trying to guess the timing, the key is to understand the drivers of any correction in order to assess new investment opportunities.

Post-election Views or Much Ado About…

Well, we can’t say nothing. We aren’t going to rehash the election surprise. What we will do is share our views on the post-election market behavior, outline a possible scenario and actions we are considering and what we will be watching for over the coming months and years.

What happened? Virtually no one in the financial world predicted a rally immediately following a Trump victory, which also very few people predicted. For the record, the S&P 500 opened the day after the election, November 8, at 2130 and closed at 2182 on November 16. This equates to a +2.4% rally that leaves us just below the all-time market highs hit this past August. Now the underlying story is a bit different. During this same 8-day period financial stocks, particularly banks, rallied over +10% and some individual stocks by close to +20%, but many tech companies like Amazon fell by -3% or more. Healthcare and bio tech have also experienced a nice bump up. Bond prices have been knocked down driving yields on the 10-year Treasury bond from 1.88% to 2.35%; right at the 1-year high.

It’s important to note that other than bank stocks making a very decisive move up, none of these numbers are, in and of themselves, eye-catching from an absolute perspective. We have seen most of them in the past 12 months.

What do we see driving this behavior?  Right now we surmise the biggest driver is speculation on the third derivative of policy expectations. It is clearly not investing based on observed facts. Many market participants have made big rotations based on policies President-elect Trump hasn’t made clear, haven’t been implemented and whose effects are just hypotheses, i.e., speculation on the third derivative. Here is a summary of the big themes:

  1. Bank regulations get relaxed or go away so banks are more profitable
  2. Obamacare gets changed or eliminated and capping drug prices is not on the agenda, helping health care and biotech companies
  3. Fiscal stimulus, primarily through infrastructure spending goes up, international trade gets choked off, taxes are lower, all driving inflation and interest rates which helps banks and generally hurts bonds.

Now we don’t argue that these sound directionally right. However, the market movement was quick and in some areas sharp. Quick and sharp are not words often associated with governmental change and therefore we believe the market has over-reacted.

What do we hypothesize will happen over the next 12 months?  Here is a working, third derivative hypothesis, roughly in order of our conviction. It is not precise as we are using the third derivative —  think compass orientation not laser targeting.

  1. We get fiscal stimulus and lower taxes
  2. Rates and inflation rise, but not dramatically
  3. Bank regulations get tweaked not thrown out
  4. The economy improves a bit.
  5. Obamacare gets changed. What’s the effect? See the third derivative, i.e., who knows?

So what are we doing?  We have not been making major investment decisions. As investors, not speculators, we don’t react to quick market moves driven by assumptions from third derivative hypotheses. We are spending a lot of time looking at how we implement our existing overweight positions to technology, healthcare and biotech. We are also looking at financials as a possible overweight. We have been selectively adding to real asset positions due to higher expected inflation and what we believe has been undo pressure on REITs and our infrastructure positions. We have been selectively selling out of some fixed income positions.

What will we be watching? We will be watching measures of economic activity that might indicate a coming recession because we haven’t had one in over 7 years. We will be looking for dislocations in the market to add/rebalance to core positions. We will be listening and looking for real policy statements and activity that give us a better idea as to how those policies will eventually be implemented. We are particularly intrigued to see what happens to US Treasury rates as they will be a good indicator of how the world judges the relative safety of our markets versus all others.

In dealing with the next few years, it will be best to embrace Confucius’ blessing (curse?): “May you live in interesting times,” and to maintain a diversified and carefully monitored portfolio.