State of the Markets
In the third quarter of 2020, stock markets continued trending upward from the March lows, resulting in positive performance across all major asset classes.
As of September 30, the global stock market (MSCI ACWI IMI) was up 8.1% for the quarter, resulting in a YTD increase of 0.5%. The U.S. stock market (Russell 3000) had positive performance of 9.1% for the quarter, resulting in a YTD gain of 5.4%. International developed markets (MSCI World ex USA IMI) rose 5.6% for the quarter but are still down 6.7% for the year. Emerging markets (MSCI Emerging Markets IMI) were up 9.8% for the quarter, reducing the YTD loss to 1.3%. Publicly traded real estate (S&P Global REIT) gained 2.3% for the quarter but is still down 19.2% for the year. The U.S. bond market (Bloomberg Barclays U.S. Aggregate Bond Index) had a positive return of 0.6% for the quarter, bringing YTD returns to 6.8%.
The total returns for major asset classes are below.
This is a phrase we have heard a lot in 2020, and it is not an exaggeration. We are experiencing things we have never seen in modern times – as a world, as a country, as individuals. While we can’t address every underlying variable, we will give our perspective on how unique this situation is from an economic and financial standpoint.
The Pandemic Economy
What makes these times unprecedented from an economic standpoint is the cause of the recession, its depth, and the path to recovery.
Most recessions are caused by excess – excess enthusiasm, excess spending, excess building, excess borrowing, excess lending, etc. This tends to happen toward the end of business cycles when things are going well but get extreme. Sometimes the problems are fixed on the fly, leading to further expansion, but sometimes they are not. Often, exogenous events trigger a bump in the road, which then exposes the excess that seemed reasonable but can’t be maintained.
Once a traditional recession hits, demand generally gets cut back to reduce the excess. Less demand leads to less supply, which exacerbates the downturn. Ultimately, supply and demand find a new balance and things start to move forward again. While this sounds simple, the consequences can be complicated. Industries take it on the chin, companies shut down, debt defaults, people lose jobs, cut back spending – all as a domino effect to the changes in supply and demand.
What makes this recession different, is the sequence of events. Instead of changes in supply and demand resulting in closed businesses and lost jobs over time, a singular event – COVID-19 – resulted in instantaneous closed businesses and lost jobs. Dramatic changes in supply and demand are the aftermath. A typical recession is like a party in a dancehall that fills beyond capacity. Eventually, the party needs to shut down. And when it does, the mess must be cleaned up.
This recession is more like a party that was running fine and not pushing any boundaries. Then the power went out, the lights went off, and the dancehall went dark. Some people have dropped their drinks, some have tripped and fell, many are stable and fine, but we are all worried about when the lights will come back on. The longer we are in the dark, the more damage may be done. But when the lights come back on, the party should get back to relatively normal.
Given the cause of this recession – universal shutdown of economic activity across the country – it is not surprising that the speed and depth of the retraction is unique as well. Data from the St. Louis Federal Reserve shows:
- Unemployment rose from 3.5% to 14.7% (the highest rate since the Great Depression) in two months.
- Gross Domestic Product (GDP) saw a year-over-year decline of roughly 9% in the second quarter of 2020.
- Retail sales dropped by 12.7% in March and April.
By almost any measure, we have seen the quickest and deepest retraction ever experienced in our modern economy.
When the lights of our economy went completely dark, the Federal Reserve and the federal government stepped in with the equivalent of backup emergency lighting. They provided fiscal and monetary stimulus at levels never before seen. Since then, some, but not all, of the regular lights have come back on with businesses finding their way, consumer demand increasing, and lockdown restrictions easing. With that, the economy is recovering.
But, depending on what you measure, things either look surprisingly good or deeply concerning. The chart below shows four leading economic indicators, and while retail sales have fully recovered and reached all-time highs, other metrics like unemployment and industrial production have a long way to go to get back to their former levels.
There was talk earlier this year about the shape of recovery. Will it be V-shaped, U-shaped, or something else? The answer is something else.
A K-shaped recovery implies that while some things are trending up, others are trending down. Some businesses and segments of the economy are adapting or getting back toward normal. Others are still struggling or seeing changes in demand that may be permanent. As mentioned earlier, the longer we are in the dark, the more damage may be done.
This is why such significant support from the government is needed and justified. Normally, in recessions, the Federal Reserve lowers interest rates and provides reserves so banks can increase their lending, expecting the banks and businesses to work it out and find a new equilibrium. But in this unique environment, banks can’t judiciously underwrite loans, nor can they diversify risk across regions or industries if every company is affected the same way at the same time. This is why programs like the Federal Reserve’s Main Street Lending Program, the Small Business Administration’s PPP loans, and direct-to-consumer stimulus checks are so important in this unprecedented economic situation.
Not everything the government does is perfect. The initial stimulus of $3.5 trillion (combination of CARES Act, other legislation, and tax deferral according to DataLab) may have overshot or may not be enough, which is why the government has to be flexible and reactive going forward.
The Pandemic Markets
The U.S. stock market has had a remarkable recovery since it bottomed in March, with the Russell 3000 returning to a positive performance of 5.4% as of the end of the third quarter. Some see this as a significant disconnect between stock performance and our economy, but perhaps it’s not.
The markets are always forward-looking and pricing in all the potential scenarios – from worst-case to best-case – based on their probability of occurrence. When the pandemic first arrived, and before there were any meaningful efforts to control the outbreak or thwart the economic downturn, the stock market reacted extremely negatively. It was pricing in a high probability of a worst-case scenario.
While the early outbreak was not easily contained, massive spreading across the country was initially avoided. Even now, the situation around the virus is not ideal, but therapeutic treatment, testing, and capacity have all improved, leading to better recovery and lower mortality rates. This took the worst-case scenario off the table.
The extreme level of monetary and fiscal stimulus has also supported stock market returns, because more money in the economy should ultimately benefit corporate profits. The markets recognize that the power is still out in the dancehall, but they like the emergency backup lights brought in by the government.
The markets are not pricing in a best-case scenario, but they are optimistic about the speed and trajectory of the recovery. However, like the economy, we are seeing something K-shaped in the stock market. Some companies are thriving in this environment, which is reflected in their high stock prices and high valuations. Others are struggling and their future is not clear. It should not be surprising that a disparity in financial performance between companies would be priced into their stock prices. What is surprising is how concentrated this disparity is.
A small group of tech companies – FAAMG (Facebook, Apple, Amazon, Microsoft, and Google) – have been leading market performance for several years. These companies have operated well in 2020, and their stock prices have increased significantly. This resulted in great investment returns, but also significantly higher valuations and significant concentration within the U.S. stock market. As of the end of Q3, these top five stocks compose just under 25% of the total value of the S&P 500 index.
Companies become market leaders for good reasons. They generally have monopoly-like business models, high product demand, and great profit margins. However, history shows that companies that grow into the zone of highest market capitalizations do not stay there forever.
The chart above shows which companies ranked as the 10 largest in the U.S. market historically as of the beginning of each decade. While the details may be hard to see, the trends are clear. Companies that are at the top often get replaced by others over time. These moves can result from industry shifts (GM, Exxon), competition (IBM, Walmart), regulatory changes (AT&T, Citigroup), reversals in valuations (Cisco, Intel), and company missteps (GE, Kodak, Xerox).
You don’t want to bet against market leaders, but you also don’t want to double down on companies when they at their highest valuations. Diversification can be challenging in the short-term but is critical to achieving long-term success.
As always, thank you for your trust and confidence. Please reach out if you have any questions.