THESE ARE UNCOMMON times, with the resurgence of COVID, a nascent economic recovery, and the imminent election making 2020 a remarkable (and remarkably troubling) year. The economy is sending out mixed signals, and while the stock market has been booming of late, the rally has been led narrowly by a small group of big-tech companies. But the aggressive support from the federal government and the Federal Reserve has, we believe, placed a floor under the economy. And of course, crisis is no stranger to either the economy or the markets. We’ve gotten through before, and we will again.
Post-Election Markets Generally Strong
As to elections, the stock market has generally risen over the several months that followed whether the incumbent has won or lost, no doubt because uncertainty about economic policies was lowered: The market hates uncertainty. Of course, there’s no guarantee that the market will follow suit this November.
We’d also advise clients not to plan their portfolios around presumed election outcomes. For example, in 2016, many investment strategists suggested that a “Clinton” portfolio would favor large growth companies while a “Trump” portfolio would tilt more toward small-cap value. But even though Trump won, it’s been a large-cap growth market (a supposedly “Clinton” market) since then. Our advice? Don’t try to match investment strategy to political labels; it’s probably a waste of time.
Second-Quarter GDP Overstates the Negative
Real-GDP growth in the second quarter came in at a wrenching 33% annualized decline—the work of the pandemic and the worst result ever posted (yet marginally better than expected). However, that number assumes we’ll see three more quarters with the same catastrophic results. While the course of the economy is especially hard to predict in the current environment, we believe we’ll see growth again in the third and fourth quarters (we’re already seeing some green shoots of recovery), and an overall 5% decline for full-year 2020 versus 2019.
However, not surprisingly in light of the resurgence of the virus, economic growth has apparently plateaued, and the “U”-shape of the recovery that we predicted will probably become wider—indicating a longer time until the restoration of normalcy. But while a second contraction remains a risk, we don’t expect to see one.
A Strong Stock Market in a Weak Economy?
Many investors are puzzled by the current divergence of economic and market performance. How can the market power upward in a quarter with disastrous GDP growth? But this isn’t an anomaly: Equity performance has tended to be better than average after periods of negative growth: about four percentage points higher over the following 12 months and three points higher over the following three years.
What accounts for these counterintuitive results? Possibly investor overreactions when the economy is contracting, pushing stock prices down below their fair values. In reaction, prices spring back as, or even before, economic conditions ease. We’ve seen this reversion in the current market. But so far it’s been a concentrated recovery particularly strong in the much-vaunted “FAANG” stocks (Facebook, Amazon, Apple, Netflix, and Google/Alphabet). In fact, they now account for fully 22% of the market by capitalization, up from 16% last year. In contrast, the other 495 companies in the S&P 500 are, on average, down 5% this year to date on a cap-weighted basis.
While any market rally is a good thing, we’d be happier if it broadened out to include more value stocks and small-cap names.
Investment Opportunities Emerging
Every market environment—especially troubled ones—produces opportunities, and we’re taking advantage of them in our portfolios. In response to the pandemic, as stay-at-home work and leisure activities continue (some of which are likely to persist after the virus has dissipated), carefully selected tech and communications companies are obvious choices. So are select health care providers. Not so obvious are certain consumer-discretionary and consumer-staples stocks. Many traditional retailers, for example, are updating their business models in light of a trend toward on-line shopping that was gathering force even before the pandemic arrived. Some traditional businesses in every sector will disappear, but the survivors will come out stronger and more efficient.
At the same time, we’re remaining wary about industries that have been particularly hard-hit by the health crisis, including airlines, restaurants, and hospitality. We don’t think any industry has been irreparably damaged, but we’d proceed slowly with those that have been especially challenged.
As important, we’re not redefining our investment-management process, which remains rooted in disciplined research and security selection. We continue to focus on value (inexpensive companies); price momentum (recent strong performance); strong profitability; high quality (strong balance sheets, for one); and smaller company size. These factors have historically been predictors of good performance, and we don’t see that changing.
Fixed Income: A Time for High Quality
With the Fed committing to continue full-throated monetary accommodation (ultra-low rates, liquidity infusions into the financial markets, and aggressive asset purchases) we expect short-term interest rates to stay in the 0% range for years. The bond market is pricing in no Fed-funds hikes until 2023 and doesn’t expect longer-term rates to get anywhere near 1.5% over the next five years.
With all these measures in place, the strong bond-market rallies in credit and in municipals are probably running their course. Accordingly, we’ve been reducing risk in our fixed-income portfolios, focusing on moving up in quality among our issuers of both taxable and municipal bonds.
Bringing It All Together for Clients
Our many investment teams are working together in building client portfolios that target today’s opportunities while mitigating risks. Our goal remains delivering the highest returns to each of our clients with the lowest risk. And one effect of the latest crisis has been to drive home the reality of risk. Many investors found that living through a severe market downturn is much more painful than they had imagined. And so our focus on downside protection in our portfolios is appropriate and key.
We can’t eliminate market volatility. But by assembling resilient, diversified portfolios that participate in up markets and help protect against market declines we can give our clients a smoother ride. We can take them off the roller coaster that they all hate!