Market Comment May 2020

Don’t bet against America; you can still buy the dip as the market rebounds

History has shown that the SPX has returned to growth after significant drops many times. For example, the index decreased by 34% within a month after the Dot-com bubble burst in 2000, started rebounding in 2002 and had surpassed the dot-com high by 2007…It then decreased by 16.9% within a month during the “great recession” of 2007-2009, during which it lost a striking 57% of its value, yet by 2013 it had bounced back to the previous high of 2007 and kept rising since for a decade…

Likewise, history has shown that the US has easily surpassed all health-related crisis that abruptly shocked the stock market. Epidemic related sell offs have witnessed a rebound within months after an unexpected occurrence of a virus outbreak caused a sudden drop into major indices. Specifically, the S&P declined by 6% within a month of the SARS virus outbreak in 2002, yet rose by 13% within a year after the start of the epidemic.  A decade later MERS appeared causing an index drop of 6% within a month, yet the S&P had risen by 14.3% within a year after the outbreak.

It goes without question that the corona virus crisis was not an economic bubble related one, though inevitably it left an impact into the real economy, both from the side of supply and demand.  The issue is that authorities decided to shutdown economic production and lock in the consumer, which also suggests though that a quick recovery should be due. The US economy was growing at a healthy pace before the virus outbreak with healthy corporate earnings, record low unemployment and low inflationary pressures, when political leadership decided to artificially freeze economic activity. That caused US Manufacturing PMI to be revised lower to 36.1 in April 2020, its lowest reading since early 2009 as output, while new orders and exports all fell at record rates due to measures implemented to contain the COVID-19 outbreak. In the service sector and in manufacturing, purchasing managers are reporting some of the longest wait times on record for supplier deliveries, as the crisis is making it impossible to get some of the things they need. Employment also significantly declined and the yields on  long term10-year and 30-year U.S. Treasury securities fell below 0.40% and 1.02% respectively, showing uncertainty.

The sharp drop in the S&P valuation though seems to have had already priced in a worst-case scenario, one that expected corporate earnings drop greater than a level of 20% due to the virus threat. Based on prof Yardeni’s research published estimates, the analysts’ consensus earnings for 2020 have dropped to 128 from the actual level of 163 (21% reduction). Such a pessimistic scenario has yet not materialized, as the blended earnings decline for the first quarter is -13.6%. Based on the general analysts’ consensus of Q1 earnings estimates at 33.19 (with 39.15 actual last year), the earnings decline is not expected to exceed 15%.  A return to earnings growth is projected in Q1 2021 (12.2% from FactSet).

From its record close of 3373.23 to the bottom close of 2237.4 of March 23 the S&P corrected by 50.7%, far more than the expected earnings decline for the year. As a matter of fact, six sectors reported year-over-year growth in earnings, led by the Health Care and Utilities sectors. In the Healthcare, Technology, Consumer staples and even Consumer discretionary sectors at least 65% of companies reported earnings above estimates.  

According to FactSet, the forward 12-month P/E ratio is 20.4, which is above the five-year average and above the 10-year average. Considering the particularly low inflation, based on the “Rule of 20” (p/e plus inflation equals 20.4 plus 0.3, being slightly above 20), it could be argued that the index is rather fairly priced, though higher than its previous estimates at the start of the year. The Consumer staples 12month forward p/e stands at 19.1 and at 16.2 for the Healthcare sector, below the market S&P500 average of 20.4

Returning to growth

A slow recovery in economic activity now begins to be priced in, as various governments have started lifting restrictive measures and hopes for medical advancements concerning medication and the vaccine have fueled the S&P’s recovery from its low point of 2237.23  on March 23, a bottom from which the S&P 500 has rallied nearly 25%. The broader market average has also retraced half of its initial drop from its record high.

A rebound in oil prices from a decade record low of $18.84 in April (the benchmark for US oil, fell as low as minus $37.63 a barrel) shows hopes of increased demand and that manufacturing production is about to pick up. Positive earnings surprises were reported by companies in multiple sectors, led by the Industrials sector.

The steepening of the yield curve (with a fall of shorter-term treasuries and a rise in longer term yields) since March restores expectations of healthier long-term growth. A steepening curve typically indicates stronger economic activity and rising inflation expectations and increased supply of bonds that means companies seek financing to resume productive activities.

The US has also previously proven its capacity of a pragmatic response to solve the crisis through monetary and fiscal policies that have been extremely powerful and almost immediately endorsed. The government is about to raise a record $96 billion in its refunding auctions for stimulus. Mnuchin stated he would borrow money long term to lock in the low interest rate as the fed funds rate is near a record low close to 0 reflecting some fear in the short term, while the reintroduction of 20-year bonds will help drive up long-end rates. Many investors see the curve steepening further, as they expect a fourth round of fiscal stimulus (“Cares 2.0”), as the Fed balance sheet is expanding to 6T. According to Goldman’s Kostin’s note, “the Fed’s actions, the virus’ slowdown, and the checks sent to Americans are more than enough for this rally to keep going.”

It is important to note that the Fed will address the crisis without causing an inflation problem, as the money injected to financial institutions, flows into financial assets.   The Us consumer price index fell 0.8% in April, as expected. “A big drop in energy prices pushed the headline CPI index sharply lower, but crippled demand for a range of discretionary goods and services is pushing core inflation lower too,” according to Capital Economics Chief U.S. Economist Michael Pearce. Many commodity prices fell with worries of an adverse hit in demand. Moreover, it should be noted that inflation is always a function of demand, which needs time to return to its previous levels to spark it, while people apart from wanting to save, are still reluctant to be part of large crowds in restaurants, theaters, sporting events hotels etc. When the velocity of money (the rate at which money changes hands) is falling, monetary policy which would otherwise cause inflation doesn’t seem to do so.

Where to focus on during the pandemic

Moreover, there are major companies, some worth the largest capitalization in the S&P, thus important drivers of index performance, that have benefited from this new reality of physical distancing and digitalization. Such examples include Amazon, Microsoft, Facebook, Google all of which have positive performance year to date. The list includes Apple, that reported very good earnings, and Netflix.  Technology has been performing well and should be overweight in your portfolio (BABA as the equivalent of China’s Amazon should be included for a rebound).

Healthcare companies as expected saw increased demand and interest in their services.  Besides market cap giants such as JNJ, Roche and Pfizer that have fared well, companies involved in the medicine and the vaccine such as Gilead, Abbott, AstraZeneca have seen rising performance year to date. The global healthcare IXJ ETF and the IBB biotech ETF should have been an important holding in your portfolio, including health insurer UNH.

Companies in the staples and food industry (Walmart, Nestle) are likely to maintain good performance. It is notable that food prices have risen, while overall inflation is falling. The index for cereals and bakery products, for instance, rose 2.9% in April for its largest monthly increase ever.

It is also not a bad idea to gain some exposure to the energy (XLE ETF which also has a good dividend yield) and financial sector for a rebound. JP Morgan and Visa are good candidates for your portfolio, while you can avoid travel and leisure companies whose recovery is not directly due with business including hotels and amusement parks…

In search of dividend aristocrats, it is advisable to check for companies with healthy balance sheets and low corporate indebtedness, as since the financial crisis of 2007–08, there has been a large increase in corporate debt, which in 2019 was by $72 trillion higher than that of the Great Financial Crisis. The economic downturn naturally has raised concerns on the capacity of some companies to service their debts.

Warren Buffet, reflecting on the market crash of 1929 recently stated “Never bet against America”. The market, particularly in the US, always gives opportunities for investment. You just need to evaluate the business opportunities that arouse in the right sectors around the right time and focus on those companies that can benefit from their market share and sustain their competitive advantage.