Stock prices, measured by the S&P 500 jumped a remarkable 10.7% in November, and are now up 14% year to date. November’s returns are the third best for any month over the last 20 years, led by 12.7% in April ’20 and 10.8% in November ’11. To contextualize these remarkable figures, it is worth pointing out the worst monthly returns during the same 240-month span. October ’08 saw stock prices fall 16.9% with the onset of the great financial crisis. In March ’20, COVID 19 hit, driving prices down 12.5%. Finally, in September ’02 prices fell 11% resulting from the dot com bust, 9/11 and a horrific recession (from its peak in March of ’00, the market had fallen 50% by October ’02). The market will move to the extreme, both up and down, and we often don’t know why until after the fact.
November’s jump in stock prices is likely due to multiple factors. The first, and most important, was the election of Joe Biden and Kamala Harris on November 3rd. The market responded favorably with the expectation that we will see 1) sensible, forward-looking policies to stimulate and rebalance the economy; 2) renewed emphasis on alternative energy and environmental sustainability; and 3) definitive steps taken to begin addressing some of the economic and social barriers perpetuating embarrassing levels of inequality. Importantly, the nonsensical trade war will end, and this alone will provide a boost to GDP.
Positive data was released by Pfizer/BioNTech on 11/9, Moderna on 11/16 and Astra Zeneca/Oxford on 11/23, providing a monthlong hope trade premised on economic re-opening. However, the virus is raging with new daily cases in excess of 220,000 and deaths in excess of 2,000 per day. When the vaccines are approved, the difficult task of prioritizing who receives the vaccine first will come into play. The roll out means help is on the way, but it’s not at all clear when enough of the population will be adequately protected. Nonetheless, November saw investors buying stocks with the expectation the virus will be contained.
Another fundamental driver of the recent stock price surge is corporate earnings. Q3 results were better than feared, we are seeing more companies reinstate guidance and forward expectations are high. In 2Q, earnings fell by over 20% due to the implosion of business activity in the travel/leisure sectors on fears of the virus, in the energy sector with oil prices less than $1 per barrel and in the financial sector with banks making huge provisions for the anticipated loan losses. Now, as businesses attempt to emerge from the pandemic-driven recession, stock prices are discounting a substantial recovery in earnings by late ’21.
November market activity generated a dramatic rotation from growth stocks to value stocks, along with the re-emergence of smaller cap stocks. This pro-cyclical trade is premised on a full economic recovery, rising interest rates and inflation. In my opinion, the cyclical trade has largely run its course and the economy is going to take a long time to fully recover. Stimulus aside, interest rates will remain low for a long time and there are structural shifts in effect which make a return to traditional levels of growth and inflation unlikely.
In my opinion, a drawn-out recovery does not mean that stocks cannot continue to perform. First of all, the economy is not the stock market. Second, we own select stocks in which we are confident they can generate above market returns. Growth, free cash flow and dividends remain critical fundamental qualities we screen for in our selection process. We have shifted our focus to accommodate the cyclical trade, and own numerous stocks today we would have never considered owning prior to the pandemic. We will watch and make further adjustments as circumstances dictate.
As we approach year end, we are available to review your accounts with you, with a special view towards capital gains. The good news is that returns have been solid this year and we can reserve funds for future tax payments. Tax planning, or at least tax awareness, is prudent at this time of year. Please feel free to check in with us; we are continuing to primarily work from home with limited work from the office. Take good care and please be safe out there.
Bruce Hotaling, CFA
October was a frightening month in the stock market, and not just due to Halloween. Stocks, measured by the S&P 500 fell 2.66% for the month, and are now up a slim 2.77% as of month end. Stocks were uncharacteristically buoyant to close out the summer, leaving investors scratching their heads. Then successive down months in September and October seemingly foreboded calamitous times ahead.
The election is now behind us. The world seems to have breathed a collective sigh of relief with the announcement that Pennsylvania turned out in favor of Biden. The recent surge in the stock market since election day reflects the market’s acknowledgement the US in fact needs clear and consistent policies with respect to trade, foreign relations and domestic priorities. The potential for a divided government appeases many Wall Street pundits based on the presumption a republican senate will prevent higher corporate taxes and prevent expansion of health benefits and other regulations.
Critically, the pandemic is worsening and is clearly the largest issue facing governments across the globe. The US now has recorded over 120,000 infections per day. In the wake of Sturgis, the virus is raging, particularly in the Midwest. Hospitalizations and death rates are increasing. Winter is nearing and indoor gathering will become a challenge. Until the pandemic is contained, the service side of the economy in particular will remain hostage to the effects of the virus.
The labor force has been severely impacted by the virus. While hiring has picked up, the unemployment rate remains 6.9% according to the US Bureau of Labor Statistics. Labor force participation among women is in decline and minority unemployment has soared. Services are a large and visually apparent component of the economy, and they remain well off pre-pandemic levels. Longer term the risk is unemployment becomes entrenched and economic growth stagnates. Vast government stimulus, and public/private partnerships will be necessary to boost labor force participation rates and allow for a re-absorption into the workforce.
The Federal Reserve will continue to play a critical role in the economy’s ability to get back on its feet. Interest rates are now likely to remain suppressed for an extended period. It is not yet evident what post-election fiscal stimulus might look like. Clearly state and local governments desperately need help as their tax receipts have been ravaged.
Overall, stock price multiples are historically high, selling at approximately 21.5x expected 2021 operating earnings of $161 a share. For the market to move meaningfully higher from here, gains will have to be driven by stronger earnings. In spite of the country’s economic plight, 2021 may produce near all-time high corporate profits. It is feasible for the S&P 500 to generate $176 a share in earnings by mid-2021. That was the same earnings level we saw in 2019 just before the virus descended on us. This would support what many feel is an emerging bull market in stocks.
At the moment, I see a host of opportunities in the stock market. As I have discussed before, a market of stocks is quite distinct from the stock market. Our key focus is on quality stocks showing continued improvement in earnings. Of equal importance at this moment are dividend stocks. Interest rates are historically low, and further multiple expansion is unlikely. I think this backdrop will lead income investors away from bonds and toward more attractive dividend streams.
My preference is to continue to orient around strong growth stocks, while onboarding select value and cyclical plays. I feel the digitized economy will continue to grow, and dominate the market’s attention. Further, our research is focused on alternative energy, utility, and consumer stocks. We feel that these sectors will extend the strength they’ve exhibited during the latter part of the year.
Please feel free to call us to review your portfolio. I know we have been in touch with many of you with concerns leading up to the election. We cannot discount the potential for disruption in the near term, but the longer term outlook looks better now than any time in the last several years.
Please, be safe out there.
Bruce Hotaling, CFA
Red Sky at Morning
Stocks began 2020 on a bit of a sour note before the pandemic. In February and accelerating in March, prices truly fell off a cliff as COVID-19 spread around the world. Then, as though with a flick of a switch, prices reversed on March 23rd and began a remarkable five-month long run. For some reason, September was the month prices finally chose to take a look in the mirror and pause. Measured by the S&P 500, stock prices fell in the month of September 3.8% and are now up 5.6% year-to-date. A lot of investors are surprised that they have a positive return at all considering all that’s gone on this year.
The good news is that the market has recovered from its March lows. But looking more closely, very few stock prices have actually recovered. For example, looking at several different segments of the total market on a year-to-date basis, we see troubling divergences. On one hand, the Nasdaq 100 (QQQ) is up 30%, and the S&P 500 Growth Index (IVW) is up 20%. To a large extent, these heady returns have been driven by the FAANG + M stocks (Facebook, Apple, Amazon, Netflix, Google and Microsoft), and a handful of other high-growth names. In stark contrast, the S&P 500 Value (IVE) is down almost 11%, the DJ Dividend Index (DVY) is down 19%, and the S&P 500 equally weighted is down 4%. The number of stocks not participating is reason to check one’s blanket optimism.
In some respects, the market has been trading (daily ups and downs) with an eye toward the approval and distribution of a safe vaccine against the virus. Moderna, one of the leading pharmaceutical companies working to produce a vaccine recently announced that they are unlikely to have a vaccine ready until March or April 2021. Shares of more economically sensitive stocks (cyclicals) and shares of more value aligned and higher dividend paying stocks tend to respond positively to good news surrounding vaccines. One thing I take away from this is that the market will, in all likelihood, not begin to “normalize” until there is in fact at least one vaccine widely distributed and widely accepted.
Optimistically, we are seeing a general recovery in earnings – primarily driven by the digital, cloud, and software side of the economy – spread across a range of sectors and industries. From a fundamental perspective, this is an important positive for stock prices looking forward. I think there will be continued improvement on this front and we may well see operating earnings numbers for the S&P 500 by late 2021 that are similar to 2019’s numbers. That would represent a relatively quick exit from the current recession in relation to what happened in the dot-com recession in 2001 and the housing bubble recession of 2008.
A more circumspect view is that economic change may have been catalyzed by the pandemic in ways that are not apparent yet. We are in uncharted waters. Radical change in the workplace and challenges with higher education feeding young technocrats into the new economy are works in progress. I think the pandemic has quite remarkably pulled the economy forward by several years. There are millions out of work who will need to be re-educated and re-integrated into an economic structure that may be permanently changed – and this will likely take longer than most would like to admit.
The large and uncomfortable elephant in the room is the upcoming election. At the moment, polls indicate a change in government, and this would clear the way for more fiscal stimulus. The stock market is clearly anticipating this outcome and has priced it in already. I think that the US economy, its leading role in the world, and in turn, the stock market, will be best served through more consistent, well thought-out and more clearly communicated policies from Washington.
As ever, we are watching closely. In past times when we have faced challenging market conditions, we found it prudent to focus on owning high quality assets – stocks for which we have full transparency into their pricing and their financial conditions. We also require ready liquidity, which may sound odd, but when things go wrong, lack of liquidity can be problematic.
In the meantime, please do not hesitate to call if we have not been in touch. We are working both in the office and remotely and look forward to speaking with you. Please, be safe out there.
Bruce Hotaling, CFA
A Low Bar
Stocks rallied in August, jumping 7.2% for the month as measured by the S&P 500. This is unusual, as stock prices typically take a bit of a pause while many Wall Street traders close out the summer in the Hamptons. For the year, stocks are now up 9.7%, a surprising reversal from the -19.5% returns we struggled with at the end of March. Stocks are up 5 consecutive months now, and a whopping 36.4% from the end of March.
As I’ve mentioned before, stock prices are an important leading indicator. The stock market is a discounting mechanism, an indicator of investors’ future expectations, which includes the direction of stock prices. August was a remarkable month; of the 21 trading days, prices moved higher on 17 of those days or 81% of the time. According to Bespoke Research, since 1993 (the inception of the SPY ETF which tracks the S&P 500) there have only been six other months where prices were up more than 75% of the available trading days. Interesting for us to bear in mind, after each of those frothy periods, stock prices tended to continue their uptrend for the ensuing six and 12 month periods.
The news flow pertaining to the election, the virus, and shaky economies around the globe has dominated the lens through which many investors view the stock market. While the news has stirred emotions and created a nearly impossible disconnect between what people perceive and what the stock market does, there is quite a bit of underlying support for what is propelling stock prices upward.
The primary factor behind the markets remarkable run since the end of March has been the immediate and aggressive response by the Federal Reserve. The Fed’s moves created liquidity for the markets, backstopping credit and lowering interest rates which restored confidence in the US, and around the world. The de-risking of credit markets and the expansion of the P/E (the market multiple) through historically low interest rates have catalyzed higher stock prices. A second critical factor was the quick response by Congress to provide fiscal support, putting money in the hands of those that lost their jobs. The CARES Act pumped $2.2 trillion into the economy at various levels. Another $1+ trillion is under consideration. These figures dwarf the $787 billion American Recovery and Reinvestment Act passed by Congress in early 2009 during the Great Recession.
Wall Street analysts typically over-do it, and with the onset of the virus in March, they began to cut earnings forecasts, only to see them handily beaten by actual 2Q results. Now analysts are rapidly increasing their estimates, and according to FactSet Research, are forecasting a 29% jump in earnings in ’21 (led by consumer and industrials). The pattern has been one of weak but improving data. As lowered expectations are beaten, again and again, the market has been coaxed higher supported by the relative improvement.
Somewhat hidden is the fact that the economy is recovering. The excessive damage to service, travel, retail and dining has been more than offset by the pull-forward of a massive cloud based digital economy. Work from home, school from home, shop from home are all factors that have “modernized” our economic lives in ways we would never have imagined only a year ago. The emergence of 5G, the continued expansion of the internet of things, immense cloud infrastructure and the preponderance of the distributed workspace will perpetuate this transformation.
At this point, our portfolios have benefitted from strong weights in consumer and technology growth stocks, many immune to the economic disruption caused by the virus. We are also continuing to add exposure to more cyclical companies, many heavily impacted by the virus and now clearly recovering. This balanced, or barbell, strategy will remain in place for the time being.
As always we look forward to speaking with you, or “Zooming” if that has become a part of your routine. We are always available to review your portfolios, strategize as we head toward the election and review you year-end tax planning. Typically, one or two of us are working out of the office, while the rest continue to work remotely. Please, be safe out there.
Bruce Hotaling, CFA
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