Global economies continued their recovery in the third quarter of 2020, propelling stock prices higher across most major markets. The S&P 500 Index generated 8.9% total returns for the third quarter, reflecting improving fundamentals as economies reopened. While the COVID-19 pandemic continues to pose risks to the economic recovery, progress on the development of treatments and vaccines has contributed to strength in business, consumer, and investor confidence.
The table below shows the performance of major equity indices for selected time periods.
Equity Performance for Periods Ending on September 30, 2020
|Total Return Index||Market Sector||Quarter||YTD||1-year||3-year||5-year||10-year|
|S&P 500||Large U.S. Companies||8.9%||5.6%||15.2%||12.3%||14.2%||13.7%|
|Russell 2000||Small U.S. Companies||4.9%||-8.7%||-8.7%||1.8%||8.0%||9.9%|
|MSCI EAFE||Developed Int’l Markets||4.8%||-7.1%||-7.1%||0.6%||5.3%||4.6%|
|MSCI EM||Emerging Int’l Markets||9.6%||-1.2%||-1.2%||2.4%||9.0%||2.5%|
Many sectors of the economy are recovering at a faster pace than previously anticipated. Existing home sales in September rose to their highest level since 2006, the median sales price of existing homes exceeded $300,000 for the first time, and homebuilder confidence now stands at record levels. Retail sales also increased to record levels in August, despite many sectors of the economy still struggling. This seems to indicate that consumers have shifted their spending from dining out, entertainment, and travel to other areas, especially those related to enhancing their lives within their homes. US GDP estimates for 2020 have been revised upward, and the forecasted unemployment rate for year-end has been lowered from the dire forecasts made in the spring. While declining from the previous year’s levels, corporate revenues and earnings surprised on the upside in the past quarter.
The economic recovery can in large part be attributed to significant progress made on containing the COVID-19 pandemic. The current rates of hospitalization and death are each down more than 50% from peak levels. While the US has demonstrated higher rates of infection and death compared to most developed countries, it seems most Americans are willing to accept some health risk as a tradeoff for a more normal existence. Even with the likelihood of a spike in new cases as we approach the flu season and winter, we believe it is unlikely that the economy will be shut down again.
Progress on the development of vaccines and treatments have been equally important in bolstering business and consumer confidence. According to the New York Times, there are now eleven vaccines in the final phase of development, which involves large scale clinical testing. It appears likely that at least one of these vaccines will be approved by year end, although widespread availability is not expected until 2021. Better methods of treatment seem to be reducing the rate of death among hospitalized patients, and increased speed and capacity of testing has helped to identify mild and asymptomatic individuals, reducing their transmission of the virus to others.
Although the economy and stock market have recovered significantly from the March lows, there remain notable risks and uncertainties as we enter the fourth quarter. The economic recovery has been very uneven. Many sectors of the economy are still operating at distressed levels or are unable to open. With unemployment currently at 7.9%, many jobs that were lost are unlikely to be quickly replaced. Small businesses have generally suffered to a greater extent than larger companies, and their recovery has been more tenuous. Managers stymied by uncertainty are taking a “wait and see” approach, reluctant to make big decisions or hire in this environment. Businesses within the most impacted sectors will likely need further support from the government in order to stay viable until the virus is no longer a threat. However, at this time, Congress has been unable to reach an agreement on another stimulus package to provide additional aid to these businesses and individuals.
The November presidential election also poses a risk for the market. The trading of S&P 500 volatility futures seems to indicate that the market will accept a clear victory by either presidential candidate. However, a contested presidential election, especially one that is accompanied by civil unrest, could cause a market decline.
There is also some concern that stocks have become overvalued given the increase in stock prices as earnings have significantly declined. By most metrics, stocks are expensive compared to historical averages. For instance, according to FactSet, the S&P 500 Index is currently trading at 21.7 times forward earnings compared to a 10-year average of 15.4. The higher multiple can be justified by the fact that earnings are currently depressed and are expected to increase considerably over the next several years. In addition, with interest rates at historically low levels, there are very few investment alternatives to equities that provide reasonable returns.
The positive returns of the S&P 500 Index can largely be attributed to the performance of the five largest companies (Apple, Microsoft, Amazon, Alphabet, and Facebook) which now comprise 23% of the index’s value. This is the highest level of market value concentration related to the top-five companies on record, surpassing the previous record of 18% which occurred in 2000 at the peak of the Dot-com era. These five companies have returned an average of 40.2% in 2020. Many investors now perceive them as relatively low risk beneficiaries of the trend toward a more digital economy. This infatuation with large tech companies carries a good bit of risk; of the five largest tech companies in 2000, only Microsoft has a higher market value today, twenty years later.
The performance of the five largest companies stands in contrast to the rest of the market (and some might say, the entire economy). The median return of all publicly traded companies in the US for 2020 is a loss of 13.4%. This market divergence can also be seen when comparing growth and value stock performance. So far in 2020, the S&P 500 Growth index is up 20.3% for the year while the S&P 500 Value index is down 11.7%. This is the widest difference in performance between these two market segments in 20 years.
There are a number of indicators that increased speculation is spreading within the US stock market. Through the first three quarters of 2020, there have been 235 IPOs (initial public offerings), which is on pace to be the highest number since the 439 IPOs in 2000. SPACs (special purpose acquisition companies), which raise money for the sole purpose of purchasing a private company as a mechanism for taking the acquired company public, have become a hot area for high risk speculators. In past years, SPACs developed a dubious reputation for making money for the SPAC creators and leaving follow-on investors holding the bag. Day trading through popular apps like Robinhood has been equated to a form of online gambling.
While we believe that certain sectors of the market have become excessively valued, and in some cases should be considered speculative, we note that the majority US stocks have declined in price this year and are reasonably valued based on long-term fundamentals. On balance, we believe a diversified portfolio of good quality equities at reasonable valuations offers attractive return potential as the economy returns to normal.
The Federal Reserve’s actions to suppress interest rates as a means to stimulate the economy have had a significant impact on both the stock and fixed income markets. Since its initial efforts in March there have been significant increases in the value of assets such as stocks, long-term bonds, and residential real estate. At its September meeting the Fed pledged to keep its benchmark interest rate near zero until at least 2023. This is likely to be positive for equity investors, but it is almost devastating for investors who rely primarily on fixed income securities for income.
Take, for example, the 10-year US Treasury bond, which had a 0.68% yield on September 30. This bond is considered to be very safe with almost no risk of default. A $100,000 investment in this bond would currently generate just $680 of annual income. Twenty years ago, this same investment would have yielded 5.78% and produced $5,780 in annual income. The average yield of the 10-year Treasury bond since 1927 has been 4.9%, compared to a 3.0% average inflation rate. Since the current consumer price index reflects 1.3% annual inflation rate, an investment in the 10-year Treasury bond will produce a negative “real yield”–meaning that an investor today would suffer a loss of purchasing power after taking inflation into account.
As we have noted in our example, many high quality fixed income investments, while still providing a level of safety, are no longer compensating investors with a reasonable amount of income considering inflation. It is possible to achieve a higher level of income using certain fixed income securities, but it means accepting more risk by investing in lower quality securities or by using investments with longer maturities. It also means losing some of the advantages of diversification, since lower quality investments are generally more sensitive to the economy and, as a result, have a higher correlation with the stock market. These higher-risk fixed income investments will not provide the same level of protection when a stock market correction occurs.
In the latter years of the last decade, the Federal Reserve made an attempt to raise interest rates to normal historical levels (having previously guided rates to zero to help stimulate a recovery from the financial crisis and Great Recession). Considering the current economic situation caused by the COVID-19 pandemic, it is doubtful that we will see a normal interest rate environment for quite some time. The challenge will be to continue to identify fixed income securities to help reduce overall portfolio risk, while trying to generate a modest level of return from these investments.
If you pay any attention to the financial media, you may have heard two acronyms used to describe the current stock market environment: FOMO is the “fear of missing out” and TINA means “there is no alternative.”
FOMO probably characterizes the strong flow of money into the largest tech companies and some of the more speculative names in hot sectors such as electrical vehicle production, cloud software, vaccine development, and online sports betting. We think that investors motivated by FOMO are probably taking excessive risk in the current market. This is the behavior that caused much pain after the Dot-com bubble burst.
TINA likely explains the motivations of conservative investors who are now buying equities instead of CDs, bonds, and fixed income funds. Such investors no longer find the returns of these traditionally less-risky alternatives to be attractive. Considering the Federal Reserve’s stated objective of keeping interest rates low for the foreseeable future, we think the TINA concept is likely to be supportive of stock prices for the next several years. In addition, we are hopeful and optimistic that the continuing progress on containing COVID-19 and the ongoing economic recovery will be beneficial for equity investors, regardless of the outcome of the upcoming election.
John D. Frankola, CFA Lawrence E. Eakin, Jr. Matthew J. Viverette
Vista Investment Management, LLC is a Registered Investment Advisory firm. Under no circumstances does this article represent a recommendation to buy or sell stocks. This article is intended to provide information and analysis regarding investments and is not a solicitation of any kind. References to historical market data are intended for informational purposes; past performance cannot be considered a guarantee of future performance. Neither the author nor Vista Investment Management, LLC has undertaken any responsibility to update any portion of this article in response to events which may transpire subsequent to its original publication date.