For the month of July, stock prices measured by the S&P 500 generated a strong 5.6% total return, bringing the index into positive territory for the first time since late February. As it does, the stock market is pulling more and more investors in from the sidelines, however there are ample risks to this uneasy place we find ourselves. It seems more often than not identifying the risk is relatively straightforward – the difficulty is in determining how one chooses to respond.
The obvious risk is the continued impact of the pandemic. While ultimately this will be resolved by science, it’s going to take patience on the part of all of us to get there. Vaccines are under development by quite a number of companies, but it’s unclear when they will be safely available. A further twist is whether or not enough Americans will be willing to take a vaccine, threatening herd immunity.
We don’t know the full scope of the damage from the virus, beyond the obvious human toll. According to JPMorgan, the US debt/GDP ratio will exceed 100% this year. This will be the first time public debt has exceeded the size of the economy. This is complicated by the fact that Washington must allocate additional funding. State and municipal governments are desperately attempting to maintain staff to provide essential services while balancing their budgets. States are also largely responsible for Medicaid, providing health care for over 75M.
The upcoming election is a concern; will we have a fair election, will there be an attempt to delay the election or even an attempt to hijack the office? At the moment, Wall Street is beginning to absorb the 60% odds of a Biden victory and how this might play out. It will follow the opportunity to make money. On the heels of a Biden victory, one might expect a greater orientation around climate change, decarbonization, new investment in technology and critical improvements to the country’s infrastructure. There is good reason to think Wall Street would respond favorably to honest and competent leadership in Washington.
The economy, to which corporate earnings largely correlate, is in a difficult place. The risk of a prolonged recovery is this: a “v” shape is good, a “w” is not. In 2Q, GDP dropped 9.5%, (32.9% annualized) the worst drop since 1947. Virtually every measurable aspect of the economy went into decline, especially the unemployment rate – between March and April 22.1M people lost their jobs. It will be a long time before these “lost” businesses begin to reestablish and rehire.
Today we are well into 2Q earnings reporting season. Over 80% of companies have reported earnings beats, far better than feared. It’s true, analysts lowered expectations in April and May when the extent of the damage became clear. While just beginning to show some signs of inflecting, it is not expected that operating margins will recover to their pre virus levels until sometime in ’22. The risk is not another steep drop, but a low slope recovery that drags on and does not produce enough jobs and tax revenue to restore broad economic health.
The market is bifurcated. Large cap growth stocks have returned 13.8% YTD (as measured by the IVW) while value stocks have returned -13.4% YTD (as measured by the IVE). In all my years as a growth stock investor I have never seen a spread like this. The five largest companies make up over 20% of the S&P500’s market cap. Dividend paying stocks which tend to fall more into the value category, are suffering. Technology, communication services and healthcare remain the core drivers of current market returns. Eventually, I expect this performance gap to narrow, as the economy begins to regain its footing, though there is no rush to transition away from our big growth names.
Patience is critical at this juncture. We continue our analytics and fundamental analysis to identify well positioned opportunities. It is a market of stocks, well suited to thoughtful and well-timed stock picking. As is typically the case, markets become misaligned, and investors often tend to let their emotions override their analysis. I’ve found over many years that when it’s uncomfortable, there is opportunity, and when things seem oh-so-easy, there are sharks in the water. As ever, we are here, albeit remotely. If and when you need us, please do not hesitate to call – we are happy to arrange a Zoom meeting with you. Please take good care.
Bruce Hotaling, CFA
The views and opinions stated herein are those of Bruce Hotaling, are of this date, and are subject to change without notice. Information contained in this report was received from sources believed to be reliable, but accuracy is not guaranteed. Investments are subject to market risk, including the possibility of loss of principal. Past performance does not guarantee future results. The S & P500 is an unmanaged index of 500 widely held stocks. Investors cannot invest directly in an index. The PE ratio (price/earnings) is a common measure of relative stock valuation.