In the months since the initial coronavirus outbreak, we saw the economy and markets teeter on the brink of collapse, only to recover quickly. I recently sat down with my colleague and Investment Strategist, Talley Leger, to discuss the sustainability of this recent recovery.
Brian: I’m going to start with a compliment if you promise to not let it go to your head. Your market bottom framework proved prescient in late March as extreme volatility, catastrophic investor sentiment, lopsided investor positioning, and disastrous market breadth led you to opine that the market was bottoming. Fast forward 17 weeks and the US equity market has almost fully recovered. First, what drove the market retracement and what is an investor to do now?
Talley: You’re too kind—and give me far too much credit. It’s one thing to provide investors with a framework and indicators to help get their arms around the bottoming process in stocks. It’s another thing entirely to correctly call the shape of the recovery. I admit to being surprised by the v-shaped rebound in stocks, and the fact that the market didn’t re-test the March low.
As far as I can tell, there are at least 9 tailwinds behind the US stock market:
- Massive, unprecedented and coordinated monetary policy support;
- Similarly impressive fiscal policy support;
- Still cautious investor positioning in the form of high cash balances and net short positions in stocks;
- Negative investor sentiment as expressed by persistent outflows from stocks and more bears than bulls in the individual investor survey;
- Structurally oversold conditions in the rolling 20-year total returns on stocks;
- Potential treatments for the disease caused by the coronavirus that is being researched and developed by a host of companies around the world, some of which have moved to human trials;
- Potential vaccines for the coronavirus itself that are evolving at a similar pace;
- The high-frequency economic data like weekly initial claims for unemployment insurance have improved; and
- The economy is re-opening and activity is moving in the right direction, as evidenced by the daily mobility data.1
That said, there’s also a bearish case to be made for the market, namely:
- Fears of a potentially deadly second wave of the coronavirus as the economy reopens and cooler fall weather approaches;
- The risk of a negative feedback loop between stocks and second-quarter 2020 gross domestic production (GDP) and earnings per share (EPS);
- Heightened US-China tensions;
- Overvaluation; and
- Tactically overbought conditions.
All valid points, any one of which could be the catalyst for a near-term pullback in stocks.
Nonetheless, I remain compelled by the comparative breadth and scope of the bullish case, which leads me to believe investors should consider any short-term turbulence as a long-term “buy and hold” opportunity.
Brian: I, too, am compelled by the comparative breadth and scope of the bullish case. I think the adage is now don’t fight the Fed and every other central bank in the world as well as the European Commission and the US Congress. Addressing your bear case, there has already been a new surge in cases and while the US economy is slowing, it does not appear to be collapsing as it did during The Great Shutdown. Mobility may have plateaued (I, for one, haven’t gone to too many places in the past few months) but it does not appear to be collapsing. For the time being and until we make a medical breakthrough, I suspect we will take proper precautions—masks, outdoor gatherings, social distancing—to avoid the draconian shutdowns and disastrous economic collapse of earlier in the year. Valuations, overall, are elevated but the discount rate keeps falling. In a near-zero interest rate world, I suspect we need to get comfortable paying higher multiples on equities.
Regardless of whether there is a near-term pullback, I think we both believe that weak, protracted recoveries complete with overly accommodative monetary policy is good for equities in the long term. How are you positioning for a protracted recovery?
Talley: From a sector and industry perspective, we’re starting to see hints of cyclicality returning to the marketplace after taking the last several weeks off (read: summer doldrums).2 Within technology, semiconductors are making fresh highs relative to software. Elsewhere, both the industrial and materials sectors are firming. Lumber continues to surge, and the homebuilders are still acting well. We’ve also seen copper and the other metals rally (e.g., zinc, tin, nickel, aluminum and silver).
While making pure, directional calls on the cyclical or defensive sectors of the market are risky, my long-term optimism forces me to take a bullish stance on the US stock market and economic recovery. Like-minded investors should think twice before hedging away the advance.
Not to obsess about a near-term pullback, but does the market’s concentration in a handful of technology companies concern you at all? While the S&P 500 Index may be positive for 2020, can the same be said for most S&P 500 stocks?
Brian: The biggest challenge in trying to time the market or appropriately hedge your portfolio is knowing when to re-risk. Would I be surprised if we see some of the high-flying drivers of the market underperform the more economy-sensitive segments or even give back some of the recent gains? No. History suggests that corrections happen often.
But again, it’s a timing issue. Equity investors must ask themselves about the types of businesses they want to own for the long term. To me, it comes down to which businesses are the disruptors and which businesses are being disrupted. The high-flying winners in this market are disrupting the way the economy, business, and society operates. We may end up paying higher equity multiples on those businesses than for the broader market but would also expect their earnings to grow faster than the broader market.
I’ll give you the final word. How do you view the recent weakness of the dollar? Is this the catalyst to unlock the deep value embedded in international markets?
Talley: The Federal Reserve (Fed) has embarked on a seemingly open-ended commitment to buy securities until the economic and labor market outlooks improve substantially.
An important consequence of the Fed’s unprecedented balance sheet expansion is the weakness of the US dollar, which should reinforce the blossoming rally in international markets, especially in emerging markets (EM) and Chinese stocks.
If quantitative easing (QE) represents a choice between interest rates and the US dollar, the Fed has opted to save growth and jobs by loosening the monetary screws and inflating the money supply at the expense of the currency. From that perspective, it’s reasonable to expect the US dollar to weaken further if the Fed keeps such an abundant supply of currency in circulation.
To your point, structural underperformance from Chinese and EM stocks – until recently – has compressed their price-to-sales ratios to deep discounts compared to the world index and history.
While valuation is a good starting point for an investment thesis, it isn’t enough on its own. Attractive valuations coupled with a weakening US dollar and improving economic growth abroad could be a potent tonic for unleashing the potential rewards presented by EM stocks and so far, it appears to be working.