Market Performance Recap: Stocks Rally to New Highs

The sharp rally of Q2 continued into Q3 with large cap US stock indices hitting new all-time highs before a pullback in September. As the US economy slowly reopened for business, the Russell 1000 rose +9.5% in the quarter and is up +6.4% year-to-date through September. The upswing was once again led by technology, consumer discretionary, and industrial stock sectors. US small cap stocks were positive for the quarter, though not as strong as large caps, with a gain of +4.9%, but remain off -8.7% year-to-date. The non-US MSCI EAFE developed country index gained +4.8% for Q3, now down -7.1% for 2020, while the emerging market index added +9.6% in the quarter and is down only -1.2% year-to-date. Bond prices were steady during Q3 as Barclays Intermediate Gov’t/Credit bond index edged up +0.5%.

Economic & Market Discussion: Gauging the Election Impact

The Presidential election is fast approaching, bringing a rash of fear-inducing headlines. Will the election outcome affect the track of the financial markets? Should we get defensive to protect portfolios from potential policy changes of a new administration? Here is how we view the upcoming political event.

• Elections Are Usually Positive – For the past fifty years of Presidential elections, the S&P 500 stock index has gained about +4% on average for the three months following a Presidential election. The chart below shows that the market usually drives forward after an election regardless of who is at the wheel. The key takeaway is that Presidential elections are but one factor in determining market direction, and are usually not as powerful as the three fundamental factors we track: corporate earnings growth, interest rates, and market valuations.

• Manage to Actual Policy Shifts – While much has been written about what each candidate will do post-election, our view is to wait for policies to be enacted before adjusting our asset allocation strategies. In the short term, we expect supportive fiscal policies to continue to help the economy recover from the negative effects of the pandemic. Beyond that, we know that major shifts in trade or fiscal policy usually take time, and are often modified to less impactful new legislation. On the monetary side, the Fed has prioritized employment over inflation which keeps rates low and provides support for market valuations. Therefore, our most prudent course is to be more reactive than proactive with regard to post-election fiscal policy changes.
• Contested Election Risk – A worrisome development is the potential for a contested election which could delay the final outcome. This scenario would occur if one or more state votes are challenged and subject to review and possible recounts. While specific rules and margin thresholds may limit the actual recounts, any uncertainty will be viewed as a negative by the markets until resolved. Once resolved, we believe investors will move on and refocus on the economy. We will, of course, monitor any such developments closely.

The history lesson on Presidential elections and investments: Elections matter less for markets than most anticipate, so don’t be too defensive in the face of potential political shifts. Instead, focus on the current economic scenario. While today’s pandemic recovery track is unique and uncertain in many ways, we remain positive on the markets and the economy following a victory by either party.

Portfolio Strategy: Optimism Amid Headwinds

Despite market choppiness during the past month and uncertainty regarding new fiscal stimulus, we believe that two key elements will continue to support the markets: synchronized global economic recovery and extremely low interest rate policies. As such, here is how we are managing portfolios going forward.

• Stay with Stocks – Even with the strong recovery rally, we believe that stocks continue to show favorable relative value compared to other asset classes. Therefore, we hold slightly overweight equity allocations for most portfolios.
• Quality Rules – Our emphasis for both stocks and income-producing securities is on quality during the continued pandemic-induced uncertainty. We favor investments with a margin of safety, such as large cap US tech and health care stocks, as well as US Treasury and investment-grade bonds. 
• Maintain Flexibility – As the economy continues its recession recovery, we expect new opportunities to arise. We intend to seek attractive new investments in credit as well as stock areas that develop over the next several quarters.

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.