September lived up to its uncordial reputation, serving up a market correction after two months of strong gains. Despite the pullback, the third quarter closed with the stock market posting its best back-to-back quarters since 2009. The remarkable recovery from the lows back in March, when the market lost over one-third of its value in just five weeks, has been fueled by:
- Continued progress toward more-effective therapies in treating COVID-19, and a vaccine which is expected to be widely available by the first quarter of next year. Many businesses have reopened under stricter protocols to prevent the spread of the virus from overwhelming the health care system during the fall and winter months.
- Extraordinary measures the Federal Reserve and U.S. Department of the Treasury provided to bring relief to the economy. Unemployment claims have fallen from over 17 million in July to just over 11 million in September as furloughs have abated.
- Evidence that the pandemic has accelerated trends which will ultimately lead to productivity growth, as businesses have rapidly assimilated technological innovations to adapt to this new normal.
A Sharp, but Uneven, Recovery with Profound Long-Run Consequences
As a result, the stock market regained new all-time highs in late summer, indicating the bull market had resumed and the precipitous declines of early spring could be seen as a severe, but temporary, correction, as opposed to an extended bear market. Many anticipate a continuation of the sharp “V-shaped” economic recovery. However, we believe such conjecture ignores two important points:
- Economic recovery has been uneven. The shape of the recovery should more correctly be stylized as “K-shaped”—depicting how, after a sharp fall, the divergence in fortunes between winning and losing sectors during the pandemic has accelerated. We have clearly not all been in the same boat during this storm, as we first observed in early May. While the technology sector has boomed, and the manufacturing and residential housing sectors have boosted the recovery, many sectors which depend on people gathering to do business—for example, the leisure, hospitality, travel, and retail sectors—have been left stranded. The energy and financial sectors have also experienced lasting collateral damage as oil prices remain depressed and the prospect of ultra-low interest rates for several years casts a long shadow.
- The pandemic has caused permanent changes to the world in which we live, which will have profound long-run implications in many areas. We explore these issues in our “Road to Recovery” series, in which we assemble panels of subject-matter experts to discuss the strategic impact on private capital markets; innovations in the global supply chain; the post-pandemic economy; whether business owners should consider buying, selling, or holding their companies; and the future of higher education.
The speed and severity of the stock market downdraft and equally sharp, but uneven, recovery has demanded an unemotional, disciplined, and highly selective approach to successful navigation. We believe our investment strategies, designed to help our clients meet their financial goals with the highest probability of success, have performed well during these challenging times.
Capital Market Returns and Investment Strategy: Public Markets
Our models, which dictate how much risk to allocate in portfolios, are still not leading us to conclude that stocks are extremely expensive relative to bonds—a precondition which normally signals a high chance of an extended bear market, as evidenced in 2000 and 2007. With short-term interest rates at zero and the Federal Reserve indicating it is not likely to take action until 2023 at the earliest, there seem to be few compelling alternatives to stocks. Most Treasury bonds yield under 1%, so a dividend yield on the stock market of just under 2% provides a meaningful way to generate income for portfolios if it can be sustained and grown.
Earnings for the S&P 500 index are expected to grow by more than 25% in 2021, bringing its forward price-to-earnings multiple down to around 21 times, or about 40% above its long-run average. Though elevated by historical standards, if these earnings expectations can be met, the comparison of dividend and earnings yields against Treasury bond yields still do not represent an extremely overpriced stock market. The yield curve (the difference between long-term and short-term Treasury bond rates) also remains steep against a backdrop of stable inflation expectations, signaling the Federal Reserve’s stance is accommodative of future economic growth. Corporate earnings have continued to exceed expectations given the size of the economic shock experienced during the Great Lockdown.
Moreover, stocks continue to enjoy the tailwind of positive momentum relative to bonds. One measure on which we are keeping an eye is the rate of change of corporate bond spreads relative to Treasury bonds, which we view as a good proxy for investor risk appetite. These remain generally quite high, despite evidence that the pace of corporate bankruptcies is slowing. However, most of the weakness is concentrated in the distressed energy sector.
Many have pointed out that stock indices have become alarmingly dependent on the performance of a handful of stocks. However, we do not find this to be concerning; while Facebook, Microsoft, Apple, Google, and Amazon may make up only 8% of the sales of the Russell 1000, their 14% contribution to the net income of the Russell 1000 index is not too far away from their market cap weight of 18%. We also continue to emphasize domestic stocks over international exposure. The decline in corporate profits in the U.S. was less severe than in international markets this year—resulting in a lower hurdle for the domestic economy to return to previous levels of activity, output, and profitability. In addition, the pace of the American recovery is off to a stronger start than in international markets.
We are busy updating our long-term expected returns across the investable opportunity set, as we always do at this time of the year. Given the challenges of today’s starting point, with zero returns to low-risk investments and elevated valuations for riskier, higher-growth investments, creativity will be required to meet client goals. We will continue to lean on the process we have deployed over several market cycles to remain disciplined, agile, and highly selective.
We expect three interrelated issues to influence the near-term outlook:
- Further progress in containing the coronavirus pandemic during the fall months as schools and colleges return to campus. Policymakers have come to appreciate just how blunt a complete lockdown across the entire economy is given the enormous collateral damage it has on the economy and jobs. We are increasingly likely to see more targeted lockdowns to combat flare-ups as testing and tracing become more available and effective.
- The possibility of additional fiscal stimulus to bring further relief to the economy. While the economic recovery has brought the unemployment rate down to 7.9% in recent months, the momentum in job gains is slowing, and there are signs of permanent job losses increasing. Bipartisan consensus on what to emphasize in such a package has been more difficult to achieve than earlier this year when the economy was staring into the abyss.
- Most significantly, the U.S. presidential election. Since 1926, no president has been successfully re-elected when an economic recession has occurred two years prior to the election. Unfortunately, the possibility of a contested election looms large amidst bitter partisanship. Markets will be particularly focused on what the result may mean for the design of future stimulus packages, corporate tax rates, and trade policy with China. A Democratic Party sweep, in which it gains control of the White House and Senate and retains control of the House of Representatives, is key to its ability to advance its agenda.