There’s a game I used to play as a child where friends would offer each other the ability to answer an unknown question truthfully, or, accept a dare to complete some unknown challenge that often had the potential to be quite embarrassing. Yes, it was quite a silly game with a broad array of repercussions, but it’s been on my mind a lot recently.
It seems as though investors are asking the market, and maybe life in general, to play a game of Truth or Dare these days. We are trying to comprehend the fact that most markets have completely recovered from the COVID-19 related selloff earlier this year, but the pandemic is far from gone and the underlying economy is still struggling. So, investors should be demanding to know the truth about whether this incredible market price appreciation is justified. But instead, it feels like the market has accepted the challenge of a dare to keep going higher and higher regardless of whether it is justified or not.
Markets in Review
Following the market’s 35% drop in Q1 and the subsequent rally off the lows in Q2, the overall market continued to grind higher throughout most of Q3 as the potential for economic recovery and a temporary decrease in new COVID-19 infections brought continued optimism to some market participants. Most gains occurred in July and August. However, renewed pandemic fears, political and economic concerns brought significant volatility which drove the market back down in September.
The Dow Jones Industrial Average gained 7.6% in Q3, yet it remained down -2.7% on a year-to-date (“YTD”) basis. The S&P 500 grew 8.5% in Q3 but was still down -1% from its February 19th high as of the quarter end. In contrast, the technology-heavy NASDAQ Composite clearly led the rally as it returned 11.0% in Q3 and was up 24.5% YTD.
Value based investments continued to underperform on a relative basis for now, as the Russell 3000 Value Index has lost -14% YTD even with a 4.8% gain in Q3. The Russell 1000 Value Index demonstrated similar results with a -13.4% YTD return following a 5% gain in Q3. However, the worst performers continued to be small and mid-sized capitalization companies which are very sensitive to economic conditions. The Russell 2000 and the Russell 2000 Value Indices were down -9.6% and -22.9% YTD respectively following moderate gains in the quarter. U.S. fixed income assets returned 0.6% for Q3 as demand for Treasury bonds faded due to lower yields.
Figure 1: Performance through 9/30/2020
Central Banks, Fiscal Stimulus and Market Activity
Some equity investments directly benefitted from the pandemic. Healthcare companies that are working hard to design COVID-19 treatments or even vaccines have obviously seen investor interest. But, so have companies related to the “work-from-home” paradigm shift in which so many employees learned how to be just as productive from home as they are in the office. Those same individuals wanted to keep physically fit, even in the absence of public gyms, which also helped companies that produce home exercise equipment. However, the vast majority of the market was driven higher by easy monetary policy and bailout programs of central banks around the world including the Federal Reserve Bank here in the United States. Furthermore, several huge rounds of government fiscal stimulus have provided the other necessary fuel to seemingly prevent the economy from stalling out.
The Fed is currently on a buying “spree” as it looks to keep yields low, provide enough demand to offset supply and prevent another liquidity crisis like those seen earlier this year and during the past recession. The difference this time is that the Fed isn’t just buying U.S. Treasury bonds and mortgages. This time they are also using their balance sheet to purchase exchange-traded funds (“ETFs”) that are backed by corporate debt. Much of this corporate debt was issued by companies with so called “junk” ratings that are often well below investment grade. This Fed action is great for those lower-quality companies that desperately need to borrow money right now. However, is this just artificial support that will continue to create a bubble destined to pop one day soon, or is it absolutely necessary to help the economy peacefully transition back to a growth phase again? Either way, one could easily argue that without these stimulus packages and Fed policy accommodation, we would be in the midst of another full-blown depression.
Earnings vs. Price
In Figure 2, the green line represents the S&P 500 Index price and the orange line represents the S&P 500 Index earnings per share over the past 25 years. The chart highlights one of the key differences between the past few years and what happened during the Great Recession of 2008-2009.
Figure 2: S&P Earnings Per Share vs. Price
During the last recession, earnings per share (“EPS”), or the amount of profit that a company is generating for each share of its stock, began its decline from all-time highs in 2008 and didn’t bottom out until mid-2009. EPS then began to recover in 2010 and 2011. At the same time, you can see that market prices basically followed the same trajectory, moving down and then back up over basically the same time frame, and at approximately the same pace.
In contrast, once again we had record EPS levels in 2019 which were then decimated by the COVID-19 related economic shutdowns. Corporate earnings now look like they may be on the rise again, albeit at a much slower pace than their decline. However, unlike the last recession, market prices have already bounced right back up to new highs while earnings remain at levels last seen during 2016 and 2017.
There is clearly a disconnect here. Part of it is due to the fact that the COVID-19 pandemic was, and still is, an exogenous event in the global economy, and one that was so severe it required the massive degree of intervention mentioned above. The degree of stimulus and support is unprecedented and has given hope that the worst is behind us. However, we are still very concerned by the number of corporate bankruptcies that have already occurred as well as those that potentially lay on the horizon.
The recovery may well be underway, but it will likely take many months if not years before the recovery is complete. A recent survey of economists found that they generally haven’t changed their predictions since May of this year and expect that we probably won’t see U.S. GDP return to pre-pandemic levels before 2022 or later.
Economically Sensitive Stocks and Future Opportunities
For years, small-capitalization companies, and especially those with a value bias, have underperformed large-capitalization companies. This is common in late-stage bull markets where investors are attracted to the biggest companies with the largest remaining growth potential. This has clearly been the case over the past several years, and to some degree, during the post-March market recovery, as large technology companies that dominate both the S&P 500 and the NASDAQ Composite indices rallied back in force.
In the chart below, we have compared the large-capitalization Russell 1000 Index to the small-capitalization Russell 2000 Index over the past two years. The Russell 1000, represented in blue, has not only outperformed over time, but the performance gap continues to get wider.
Figure 3: Small-Capitalization vs. Large-Capitalization Performance
You can even see that the Russell 2000, represented in orange, is below where it was two years ago. Specifically, the small-capitalization Russell 2000 Index is down -11%, and the Russell 2000 Value Index is down -25% since September of 2018. In contrast, the Russell 1000 is up 16% over the same time frame.
However, we don’t believe this relationship will continue for much longer. Although large-capitalization companies with strong balance sheets and less economically sensitive earnings demonstrated strength through the COVID-19 bear market and recovery, it won’t last forever.
Typically, coming out of a recessionary environment and during the early stages of a new business cycle is when small-capitalization stocks outperform. This is largely due to their greater sensitivity to the economic cycle. Following major bear market lows, small-capitalization companies have outperformed, on average, large-capitalization companies by about 15% during the first year of bull markets, according to a study by Ned Davis Research.
Further, between the March 23rd low this year and September 30th, The Russell 1000 and the Russell 2000 have returned 53% and 50% returns respectively showing that large-capitalization companies are beating small-capitalization companies by a mere 3% off the bottom so far.
Even though an economic recovery appears to be underway, stock prices look set to remain highly volatile in the near term at least, with a lot of potential for both upside and downside surprises. The evolution of the pandemic, as well as the extent and duration of government measures to contain it as we head into a colder season, will largely determine the direction of markets in coming months and years, even considering the impact of central banks and fiscal emergency packages. COVID-19 still poses extensive challenges for professional virologists and the scientific community. However, politicians, economists and investors face similar questions and challenges. Everyone is still learning about the disease and the economic damage it caused, and so mistakes and uncertainty are inevitable.
I hope that the world will continue to seek truthful answers regarding the virus, the markets, the economic recovery, the policies and stimulus and the potentially dangerous interactions between it all. I think it’s a better play to ask for the truth right now, than it is to blindly dare the markets to go higher because we optimistically hope that a vaccine is not far off and that the Fed hasn’t exacerbated asset bubbles that have already been brewing for years.
That said, the uncertainty and potential volatility associated with the upcoming presidential election will eventually be behind us. Hopefully the brilliant scientific community will produce various methods to either eliminate or reduce the impact of COVID-19 such that life might return to some degree of normalcy in the not too distant future. It’s possible that central banks will learn from past mistakes and help us navigate through the recovery and back towards a new bull market cycle without excessive inflation or the creation of asset bubbles.
Here at WBI, we continue to focus on risk mitigation and the protection of investor capital as we carefully monitor economic data and the potential for additional market selloffs. Our strategies performed well as our active management system quickly moved out of equities and into cash and equivalents during the bear market decline. However, our portfolio management system is also working to capture as much upside as possible even during the volatile times that still lay ahead.
We appreciate your continued faith in our approach and wish you and your families both health and peace as we all navigate through these challenging times together.
Past performance does not guarantee future results.
The views presented are those of Steven Van Solkema and should not be construed as personalized investment advice or a solicitation to purchase or sell securities referenced in the Market Commentary. All economic and performance information is historical and not indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product referred to directly or indirectly in this newsletter, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Moreover, you should not assume that any discussion or information provided here serves as the receipt of, or as a substitute for, personalized investment advice from WBI Investments or from any other investment professional. To the extent that you have any questions regarding the applicability of any specific issue discussed to your individual situation, you are encouraged to consult with WBI Investments or the professional advisor of your choosing. All information, including that used to compile charts, is obtained from sources believed to be reliable, but WBI Investments does not guarantee its reliability. Sources for price and index information: Bloomberg (unless otherwise indicated). WBI Investments pays a subscription fee for the use of this and other investment and research tools. WBI Investments and Bloomberg are not affiliated companies.
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WBI managed accounts may own assets and follow investment strategies which cause them to differ materially from the composition and performance of the indices or benchmarks shown on performance or other reports. Because the strategies used in the accounts or portfolios involve active management of a potentially wide range of assets, no widely recognized benchmark is likely to be representative of the performance of any managed account. Widely known indices and/or market indices are shown simply as a reference to familiar investment benchmarks, not because they are, or are likely to become, representative of past or expected managed account performance. Additional risk is associated with international investing, such as currency fluctuation, political and economic uncertainty.
Annualized Rate of Return is the return on an investment over a period other than one year (such as one quarter or two years) multiplied or divided to give a comparable one-year return.
The Dow Jones Industrial Average (DJIA or “The Dow”) is a price-weighted average of 30 of the largest and most significant blue-chip U.S. companies.
The S&P 500 Index is a float-market-cap-weighted average of 500 large-cap U.S. companies in all major sectors.
The NASDAQ Composite Index (NASDAQ) is a market-value weighted index of all common stocks listed on NASDAQ.
The Russell 3000 Index is a float-adjusted market-cap weighted index that includes 3,000 stocks and covers 98% of the U.S. equity investable universe.
The Russell 1000 Index is a float-adjusted market-cap weighted index that includes the largest 1,000 stocks by market-cap of the Russell 3000 Index.
The Russell 2000 Index is a float-adjusted market-cap weighted index that includes the smallest 2,000 stocks by market-cap of the Russell 3000 Index.
The Russell 3000 Value Index uses the value characteristic book-to-price ratio to create a style index based upon the Russell 3000.
The Russell 1000 Value Index uses the value characteristic book-to-price ratio to create a style index based upon the Russell 1000.
The Russell 2000 Value Index uses the value characteristic book-to-price ratio to create a style index based upon the Russell 2000.
The Barclays U.S. Aggregate TR Index is calculated based on the U.S. dollar denominated, investment grade fixed-rate taxable bond market including treasury, government-related, corporate, MBS, ABS and CMBS debt, and includes the performance effect of income earned by securities in the index.
The Barclays Global Aggregate TR Index is calculated based on global investment grade debt from twenty-four local currency markets including treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging market issuers and includes the performance effect of income earned by securities in the index.