Time to Read: 7 Minutes
The US unemployment rate jumped to 14.7% in April, the highest level since the Great Depression. Manufacturing activity plunged to an 11-year low. The Leading Economic Index posted the largest decline in its 60-year history. Full-year earnings estimates have tumbled downward across all sectors. While all this bad economic news was reported, however, the S&P 500 Index advanced strongly, gaining 31.4% from its March 23rd low. As of May 13th, the benchmark is 15.2% below its February 19th record high and down only 11.6% on the year. In fact, as the three-week total of initial jobless claims hit 16 million, the S&P 500 posted its best week since 1938. As we recently discussed, we are likely in the midst of a deep recession. How can the US stock market perform so well when the economy is so weak?
Considering the stock market as a leading indicator
Ned Davis Research (NDR) has addressed this question in recent weeks, illustrating in a series of papers that the market always leads fundamentals. It led fundamentals on the way down as stocks entered bear market territory with record speed and is now advancing even as the economic numbers continue to decay.
As shown below, the stock market has bottomed an average of four months before the end of a recession.
Consider also that the S&P 500 has risen at a faster pace when the unemployment rate has been high, as illustrated below.
In addition, despite all the concern around collapsing earnings expectations, the market has also done better when earnings expectations have been low, advancing at an annualized rate of nearly 14% when the expected earnings growth is in the lowest bracket, as shown below.
Why is this the case? While there are many explanations, the simplest is that the market usually “sees” poor numbers coming and declines ahead of their arrival. By the time the economic numbers bottom out, the market has already begun to look through to the other side. As a result, returns are typically higher coming out of a market trough.
Identifying COVID-19 winners
There is another, more technical answer as to why the market has recently done so well. The table below shows the attribution of S&P 500 returns since the February 19th peak. In this analysis, NDR classified each stock as a COVID-19 “winner,” “loser,” or “neutral.” We recognize that no one is a winner when it pertains to COVID-19, but in the context of this study, a winner is a business that has not been meaningfully hindered by—or in some cases, even benefited from—the pandemic. COVID-19 losers are companies significantly impacted by social distancing measures or the stoppage in global economic activity. Obvious winners include Amazon, Netflix and Zoom; losers include Delta Airlines, Darden Restaurants and Hilton Worldwide.
As the table shows, COVID-19 winners were down an average of 6.14% as a group from the February 19th peak through May 12th whereas losers were down 33.41%. The reason the market hasn’t fallen as much as might be expected is due to the weighting in the index of each of these groups. COVID-19 winners make up a whopping 57.73% of the S&P 500 as of February 19th, almost twice as much as the losers, which explains why the index has done better than expected.
Moving forward, as the economy opens up, it remains to be seen if investors will begin to rotate into the stocks that have been hit hardest by the pandemic and push the market higher. There are still a lot of unknowns so we will be closely watching our indicators for a signal to change equity weightings.
Don’t fight the Fed
While we still remain slightly underweight stocks following our rebalance near the lows, we have made some adjustments in the fixed income portions of our portfolios. As the Federal Reserve (Fed) has been explicitly steadfast in its messaging to do “whatever it takes” to get the economy on good footing, we remain committed to one of our key rules: Don’t fight the Fed.
Not only has the Fed undertaken a massive amount of bond buying as it has dramatically expanded its balance sheet, as shown below, but it has launched a number of significant programs to stabilize the financial markets.
Two such programs are the $250 billion Secondary Market Corporate Credit Facility (SMCCF) and the $500 billion Municipal Liquidity Facility. Both programs are designed to provide stabilization in the corporate and municipal bond markets by allowing the Fed to purchase bonds—taking the Fed into uncharted territory. In fact, the SMCCF allows the Fed to actually buy certain corporate bond ETFs!
To ride the coattails of the Fed and follow our rule, we have allocated money to short-term corporate bonds and short-term municipal bonds across our models (depending on taxation of the accounts). These moves were funded from holdings in short-term Treasury securities, where we believe yields will eventually compress to very low levels to match the zero interest rate policy the Fed has put in place.
We plan to keep an eye on these holdings, especially as the Fed programs look to end sometime in Q3 2020. Also, should an opportunity arise to further increase our equity allocation, we believe the short duration of these fixed income investments will provide stability in the event of another market correction.
