Watching the SpaceX rocket transport astronauts to and from the International Space Station made for colorful conversation at our recent Investment Committee meeting. Beyond the clear engineering wonder and commercial success of the flight(s), we couldn’t help but think about parallels between today’s stock market and the mission’s. Yes, markets have shot up from their bear-market lows of late March. And yes, like the stock market, the journey has been marked by a volatile and highly-combustible backdrop. But to the point, watching the rocket’s mighty struggle to move into orbit made us think about escape velocity.
Technically speaking, escape velocity is the minimum speed needed for a free, unsupported, non-propelled object to escape gravity. At some point, a rocket no longer relies on its propulsion to provide the accelerating force pushing it through the Earth’s gravitational pull. And that’s a good thing, because fuel supply is not infinite.
The world’s central banks (e.g. the Fed, the ECB, etc.) have provided the monetary fuel to help boost the recovery. Low interest rates, support packages and a commitment to highly-accommodative policies buffeted the pandemic shutdowns and laid the groundwork for a recovery. Governments around the world have supplied their own brand of fiscal fuel via employment assurances, benefit packages, and debt relief, to name a few. And more are coming. It is estimated that monetary and fiscal support totals more than $10 trillion, more than five times the amount thrown at the Global Financial Crisis.
Following the sharpest bear market in history, these policies have helped the economy lift off the ground, but it remains far from escape velocity. Last week we received the 2nd quarter GDP, and it came in at a -32% annualized rate, the worst ever recorded. Fortunately, estimates for 3rd quarter GDP growth are running around +15%, so a recovery is indeed afoot, in no small part from all the stimulus. The market has taken notice and followed up with the sharpest rally in history. We believe those gains have a much greater chance of being sustainable if investors start to recognize the economic rocket is being boosted less by policy support and more by a ‘free, unsupported, non-propelled’ engine.
For those who have been following our weekly market updates (click here to see the videos), you will be familiar with several of our key concerns and opportunities. We have previously stated that the unprecedented retrenchment in economic activity caused by the pandemic will keep market volatility elevated. However, we also noted most of the shutdown is self-inflicted, not structural, and prone to snapping back once social distancing guidelines are lifted (see In The Throes, The Road Back, Resilient, or Delusional? and Turning the Corner here).
At BakerAvenue, we maintain analytical independence from pre-written market narratives. We remove preconceived biases from the equation and defer to our analytical output. Ultimately, our views are only as optimistic or pessimistic as our technical, fundamental and macroeconomic market analyses indicate. Our disciplines exited July in decent shape. Accordingly, our positioning remained optimistic and we enjoyed the fruits of our exposure as the market (S&P 500) posted its fourth consecutive gain.
Our views of the pace and shape of the economic ascent, and the odds of reaching escape velocity, will continue to be defined by the output from our disciplines. Let’s start with the macro backdrop. Over the past several weeks, investor focus has rightfully shifted from infection to economic trajectory (they are clearly linked). Upside surprises on incoming economic data (e.g. July’s ISM manufacturing index jumped further into expansion territory to 54.2 from 52.6 in May) continue to support the narrative of a recovery in activity and related optimism in financial markets. Housing reports and durable goods orders echo that optimism.
However, unemployment claims remain the highest since the Great Depression and are a reminder of how far we need to go to get back to pre-COVID levels of employment. Also, weaker-than-expected consumer confidence is consistent with the slowdown in fiscal disbursements, the uncertainty if they will be extended, and the surge in new case growth. The market wants to see a fiscal package get passed soon. We believe it will.
We stated previously that, as the world’s economies open back up, cases will tick higher. However, the market is most focused on hospitalization and mortality rates and the trends there are, so far at least, less bad. While the resurgence debate may affect the trajectory of the recovery, we doubt it will directionally alter the way forward. Simply, there is a high hurdle to re-engage in full shutdowns.
Regardless, broad skepticism about the prospects for a V-shaped economic recovery remain. We believe the worst of the economic contraction occurred in April, but the May through July recovery only reverses a small fraction of that retrenchment. The Fed took notice and reaffirmed their commitment to highly accommodative policy. Yields moved lower and the US Dollar fell on a ‘lower-for-longer’ rate view.
The fiscal response to this crisis (‘fiscal fuel’) has been equally impressive and dwarfs the lawmakers’ packages of the Global Financial Crisis. It is worth reminding investors that all of this liquidity has been added to the capital markets at a blistering pace. While the initial Covid-19 contraction is larger than the Global Financial Crisis we believe its cumulative impact on the economy will likely be less as long as the policy response(s) remains strong enough to cushion the blow. This ‘backstop’ makes a re-run of the March panic in financial markets unlikely, a key assumption underpinning our current positioning.
But, as stated earlier, it won’t last forever. Investor focus will soon shift towards how long it will take to get economic activity back to pre-pandemic levels. The U.S. economy was healthy leading into the COVID-19 crisis and the ensuing recession was caused by an exogenous shock. This is not a typical end to the business cycle driven by economic overheating and could hold promise for the recovery. Regardless, we believe it is prudent to be guarded and continue to suspect more of a U-shaped recovery.
We believe intensifying US-China tensions have increased uncertainty but, much like last year’s trade war, will ultimately avoid the most-dire scenarios. Election-related volatility is sure to pick up as the year progresses, but, like most elections, will play second fiddle to the economic backdrop (expect more from us on politics as the election nears).
Fundamentally, we are focusing on the trend in corporate profits and credit metrics. Mirroring the economic contraction, we suspect the pullback in corporate profits troughed in April. Visibility remains limited (more than half of the companies in the S&P 500 have withdrawn guidance), but it is improving as the reopening gains steam. Earnings surprises relative to expectations this quarter are running around 23%, a record.
We monitor credit closely as a risk metric and measure of liquidity. The credit backdrop has improved with both investment-grade and high-yield spreads more than halfway back to their old pre-crisis levels. Continued tightening here is consistent with the ongoing rally in stocks. Capital raises (e.g. secondary offerings, corporate bond issuance) have exploded as balance sheets are fortified. Defaults have ticked higher, and bear watching, but at this point we do not see any systemic risk.
Valuations are stretched as the rally (and depressed earnings) has pushed P/E multiples to the highest levels in two decades. The economic slowdown and market cap expansion has the level of stock market capitalization-to-GDP ratio (also known as the Buffet Indicator) at all-time highs. But there are still many pockets of opportunity, and when you consider other market metrics (e.g. interested rates), those elevated valuations look more palatable.
Valuation is often reviewed in the context of interest rates. On that front, the 10yr Treasury yield stands at 0.56% today, just a few basis points above its record low set earlier this year. These historically low rates make the earnings yield offered by stocks attractive relative to bonds and provides a counter-point to valuation concerns.
Sector and industry valuations differ, of course, with a record amount of dispersion (the top 20% of the S&P 500 trades at 28x vs. 11x for the bottom 20% - the widest in 20 years). Now is the time for earnings growth to take over and, encouragingly, profit revisions have trended higher over the past three months.
Technical trends continue to improve. Market breadth (a measure of participation) and relative strength carry significant weight in our work. Both are showing signs of improvement, but large-cap stocks (particularly mega-cap technology stocks) are doing the heavy lifting. The top five stocks in the S&P 500 make up almost 23% of the index (the top twenty-five make up almost 42%). So, there is room for improvement as far as participation goes.
The relative strength of various asset classes, sectors and industries is encouraging. We are seeing some strong performance coming from the traditionally cyclical side of the market (e.g. industrials metals, materials, etc.). Should investors continue to reward these portions of the market, confidence in the recovery will be emboldened.
Investor sentiment remains subdued (a good thing). There is still over $1.5 trillion in money market funds and, despite the advance, flows into equities remain negative year-to-date. The number of bulls as measured by AAII fell to only 22%. We suspect elevated volatility continues to play a role here. The S&P 500 has moved 1% up or down on over half of trading days so far this year and the Volatility Index (the VIX) has remained stubbornly high. Should those trends reverse, expect more money to enter the equity market.
Our investment philosophy is based on a dual mandate of growing, and protecting, client assets. Currently, our short-term metrics are in a neutral position, while long-term trends, which are influenced by our recessionary and bear market views, have healed (also neutral). Pullbacks and consolidations have been few and far-between since the market bottom, but we have remained active in our strategies, tilting our strategies towards areas of the market where we see opportunity.
With our cash positions now residual in nature, we are focusing on strategy positioning vs. our respective benchmarks to control risk. We have championed a ‘barbell’ approach by investing with secular winners while simultaneously allocating capital toward assets that will benefit most in a recovery. Should our base case hold, we plan to hold our positioning steady. Of course, should the backdrop start to de-stabilize, we will take a more defensive stance.
While there is notable uncertainty in the marketplace, we suspect the method by which the recent historic policy support hands off to unsupported growth will be key to watch. We will lean heavily on our disciplines to illuminate how the handoff is progressing. In the meantime, asset prices should stay volatile as investors swing from recovery optimism, to shut-down pessimism, and back again. The next few weeks will be most influenced by virus-related news flow, and specifically reports of economic traction regarding re-openings. Headlines related to geopolitics and corporate earnings will also carry significant weight.
Given the volatile and ever-changing backdrop, we believe a strategy that combines disciplined fundamental, technical and macro analyses has the best chance of generating superior risk-adjusted returns. While our forecasts are subject to revision, our commitment to client service is rock solid. Should you have any questions, please reach out to us. We are happy to share our thoughts in greater detail and welcome your questions or comments.
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