August 2020 - With the stock market back to pre-COVID levels, we are often asked, “How can this be possible?”, given that Q2 GDP was down 33% and we have a 10% unemployment rate. There is often a disparity between what is happening on “Main Street” vs. how “Wall Street” is doing but this latest difference somehow feels worse since all of us have had to deal with COVID, the lockdowns, homeschooling, and everything else which has been a result of the pandemic.
There are some plausible answers to why this bifurcation is happening, namely, the markets are forward looking, there is an expectation of an end to the virus at some point, massive Federal Gov’t stimulus, and the Federal Reserve acting as a backstop.
The market is looking to 2021. While the mutual existence of a rising market and high level of unemployment may seem counterintuitive, markets are always discounting what is going to happen and not what has already happened. Currently, the view is that things on Main Street will improve and there will be a return to a normal level of economic activity. While there are differing views as to when exactly that will occur, there is a consensus building that it will be sooner than later. As a result, investors are basing investment decisions on 2021 earnings estimates which are closer to pre-COVID levels.
All hands on deck for a cure. The current view is that the health situation is on its way to being resolved, thus there will be a return to normalcy at some point. Nearly every major pharmaceutical company and biotechnology company around the world is focused on developing a treatment, vaccine, or both. Pfizer, Johnson & Johnson, and Moderna are just a few of the companies that are in advanced testing phases of a vaccine. These companies are already producing doses in the event these vaccines prove efficacious such that they can be distributed immediately.
Federal stimulus. Another major factor in the market’s resilience has been the government’s aid during this forced closure of large swaths of the economy. Unlike prior recessions, the recent economic slowdown was forced due to government mandate to slow the spread of the virus. As a result, the government gave individuals and businesses impacted by the virus unprecedented levels of relief in the form of the Paycheck Protection Program (PPP) as well as extended and enhanced unemployment benefits. These additional benefits allowed consumers to continue to spend. Business that were closed were also allowed to retain staff and pay other bills using PPP and other CARES Act measures. The government is now debating additional stimulus which should help further.
The Fed. Finally, the last major recession during the 2008 financial crisis caused significant economic hardship as banks were distressed and credit markets froze. In other words, businesses of all sizes found it hard to borrow money to stay afloat. Having learned some lessons from that era, the Federal Reserve ensured the credit markets would remain liquid by expanding its ability to buy not only U.S. Treasuries but corporate bonds as well. These efforts have allowed banks to issue credit cards, mortgages, auto loans and keep markets functioning as they should.
Despite the market’s rebound, there is an interesting detail worth noting. The number of stocks that are driving the market to these pre-COVID high is relatively small, namely the mega-cap tech and consumer stocks such as Apple, Amazon, Facebook, etc. While there is a lot to like in these companies, such narrow market breadth is often not healthy. According to FactSet, since the February 19th prior market high through August 18th, 62% of the stocks in the S&P 500 still have a negative return.
Many of the companies still trading at a loss are in the Financial, Energy, Materials, and Discretionary sectors. This dynamic does not mean that the stocks that have done well since the March lows will now do poorly, but that there is opportunity for other stocks and sectors to support the market going forward as more of the economy reopens.
During the past earnings season, we have heard many CEOs discuss how surprised they were at the quick return of customer demand following the months of March and April. As a result, they can now issue forecasts for 2020 and this removal of uncertainty has also helped bring back investor confidence.
As the market continues through this recovery there will likely be bumps in the road, compounded by a potentially contentious election season. Markets will ultimately focus on the long term trend of earnings which is why at AMI we stay focused on finding companies that can both thrive during these troubling times but also continue to be strong businesses as the world returns to work, leaves the house and gets back to business.
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