What Comes Next?
This year we have watched as the stock market executed a remarkable v-shaped recovery from the traumatic lows it explored March 23rd. At that point, the S&P 500 was down over 30%. Since then, prices are up 37.7% (as of June 3) the largest 50-day gain ever, according to FactSet Research. May saw shares rise 4.7%, and now for the year, prices are down 4.9%. In a similar manner, the bond market has seen the dramatic cracks that appeared largely remedy themselves. Investors are breathing a sigh of relief, while asking themselves, what comes next?
When I assess the investment landscape in an attempt to reconcile where there is opportunity, and excess risk, I am of two minds. On one hand, the market itself is its own best leading indicator, and it is pointing to continued opportunities. Recession or not, the vast amounts of financial support from the Federal Reserve and Congress’ fiscal stimulus are unprecedented. A large component of the market is made up of companies whose fortunes have not been impacted by the virus; many in fact have been unwitting beneficiaries of the new economic order.
On the other hand, while the curve has been flattened and the health care system stabilized, the protracted fallout from the virus is unclear. There is not a therapeutic or vaccine on the horizon yet. This means we have the continued threat of infection, and required physical distancing and modified work protocols, which will dull the economy’s rebound. Unemployment is at record high levels, and our consumer driven economy is dependent on spending. Recovery may be further hampered by higher taxes, higher default rates on rents/mortgages, and extended periods of recovery particularly for both the service and travel/leisure industries.
Normally the principal barometer of stock behavior is earnings and forward guidance; 2Q 2020 earnings will likely be the washout of all washouts. According to FactSet Research, during the period through May, estimates for the full year fell from $177 per share to $128 per share. Sadly, this is the largest decrease in annual EPS estimates for the index since FactSet began tracking in 1996. The good news is the cuts to estimates have largely run their course and we have seen a larger than normal number of companies withholding forward guidance. The difficulty here is the highly uncorrelated behavior of stock prices going up, while earnings forecasts are going down.
The approach that has been working well for us continues to center around growth companies with high free cash flows and strong margins. These have been the driver of returns for the last few years, and I expect this to continue. We have also been taking advantage of a surge in interest in more cyclical (economically sensitive) companies, many severely punished in the downturn. I think we will see a continued snap-back, driven by pent-up demand. There is a good chance the recovery will usher in a period of secular growth along with some inflation, historically a favorable backdrop for stock prices.
While I think the recovery will be stronger than many fear, I’m not sure which letter of the alphabet it might look like. I also think we need to brace for fits and starts along the way. We need to be aware and open minded, as there will be a lot of change; think about public transportation, travel by plane, professional sports and college (according to National Student Clearinghouse, college enrollment since its peak in 2011 has fallen 10.6%). In a curious way the pandemic has amplified change.
Finally, I am hopeful the most recent crisis over racial injustice will raise critical awareness and allow fairly elected representatives to begin to effect constructive reforms. At the moment, the market’s only concern is the virus and nothing else. I view the current protests as a window into the need for attention to far larger concerns, such as the health and sustainability of our social-economic fabric, and the future security of the global environment. We will work through this pandemic, but we need to attend to more to insure vibrancy of the markets into the future.
Though we continue to work remotely, please do not hesitate to call or email, as we are all available for you. Please take good care.
Bruce Hotaling, CFA
The views and opinions stated herein are those of Bruce Hotaling, are as 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&P 500 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. This note contains forward-looking statements, predictions and forecasts (“forward-looking statements”) concerning our beliefs and opinions in respect of the future. Forward-looking statements necessarily involve risks and uncertainties, and undue reliance should not be placed on them. There can be no assurance that forward-looking statements will prove to be accurate, and actual results and future events could differ materially from those anticipated in such statements.