Where do we start? A once-in-a-century pandemic shocked the world earlier this year. Despite tens of millions of unemployed workers and economic statistics comparable to the 1930’s era of the Great Depression… stock markets posted significant gains this quarter, with some reaching near-record highs.
The COVID-19 bear market has been unique in many respects. It was driven by an external shock rather than the more typical tightening of an overheated economy. As such, it lacked advance warning and the opportunity to sidestep accompanying volatility. In addition, while it is characteristic for central banks to ease monetary conditions as a recession progresses, the massive, near instantaneous response from the Federal Reserve and other central banks was like nothing witnessed in history. These actions alone put the bottom in the stock market on March 23rd, resulting in the shortest bear market in history (shown below).
Source: InvesTech Research, June 19, 2020
WHAT’S DRIVING THIS NEWFOUND OPTIMISM?
The challenge of investing in the current environment is balancing near-term enthusiasm in the stock market with the outstanding economic and health challenges ahead. There is still significant uncertainty about what the next stage of COVID-19 will mean for us all, yet many market participants seem willing to ignore its future impact. This rally has been based on things not getting worse and the trend of economic data improving. The next phase will be more challenging as investors revert back to valuing businesses on their future earnings streams, which carry a wider range of outcomes these days.
Historically, the benefits of bear markets are that they reset valuations, ring out the excesses and redirect capital back to productive uses. Given the unique nature of this downturn, many issues from the previous cycle have not been diminished but rather amplified. Global debt levels have surged. Valuations remain at historically high levels. Frail earnings growth throughout 2019 will continue for some time. The two-tiered market, driven by investors caring less about the valuation of growth stocks, has not only continued but is now approaching extremes. Lastly, we are witnessing examples of speculation and momentum-based investing that are generally associated with market tops rather than bottoms. But, and it’s a big but, actions by the U.S. Federal Reserve and global central banks are offsetting many of these challenges – for now, anyway.
DON’T FIGHT THE FED
The actions of the Fed (and other global central banks) continue to be the biggest support for asset markets, as they have been for the past decade. Aggressive monetary policy and the initiation of quantitative easing (asset buying) as undertaken at the beginning of the 2008-2009 Financial Crisis continue to be today’s playbook, except now the policy is on steroids. The following chart shows the degree to which the Federal Reserve feels it is necessary to alleviate the pressure. It has been very clear it will be ready to further support the system, alongside government fiscal policy. While it is necessary to support the economy, these actions result in significant moral hazard. Investors are willing to increase risk as they view lawmakers and central banks as an implied insurance policy.
Source: Financial Times; BofA Global Research; Bloomberg
The unwavering belief in Fed policy as the solution to all economic woes is dangerous – just ask Japanese investors. Long-term imbalances are being created alongside a massive debt load every time the Fed steps in with such relief measures. While it has certainly supported the system in the near term, it is not a good foundation for long-term investors to be building from.
BEHIND THE MARKET INDICES
We’ll discuss the U.S. market here as it has been the golden child for global investors over the past decade. Since the March 23rd lows, the S&P 500 has shot up nearly 40%, the highest return over such a short period of time since 1933. But beneath the surface, much of the market is suffering. Most stocks remain down this year, many of them significantly so. A handful of big winners – those that have been the go-to stocks of the past bull market – are surging.
We find ourselves at an extreme. Like past cycles, it will go on until one day it doesn’t. Previous examples of such markets include the bear market of 1973 (Nifty Fifty era) – when the darling stocks of the time rose to near-record valuations while most stocks plummeted, and the 1999 technology bubble – when tech shares surged 80% as most companies in the broader index were left behind. We believe we are making history once again with the extremes unfolding in this current environment.
Through the COVID-19 bear market, the most expensive stocks got even more expensive and the cheapest got cheaper. This is a continuation of pre-COVID market dynamics – the thinking seems to be that big, expensive, high growth businesses must be safer at any price and are sure to beat the market. The chart below illustrates how important a small group of companies have been to the overall returns of the S&P 500. If you strip them out of the U.S. index, or strip the U.S. out of a global index, returns have been paltry in the recent past.
Source: MSCI, Datastream, Bloomberg; Minack Advisors
The Canadian marketplace continues to trail the U.S., small caps continue to trail large caps, and economically sensitive businesses continue to trail technology/growth-oriented businesses. While market conditions have changed drastically in three months, our equity portfolios remain of good quality and are valued at significant discounts to their respective markets. As such, we believe our longer-term return prospects remain attractive. We have been active in our bond portfolios, seeking additional high-quality corporate investments with attractive spreads to government bonds. With yields as low as they are, few investments are competing with attractively valued equities. As such, we are being compensated considerably for the businesses we own in the portfolios.