Stocks fell last week, marking the longest weekly slide since 2019, as investors continue to digest news that U.S./China trade tensions are rising, a coronavirus vaccine won’t be widely available until April of 2021, jobs data came out worse than expected, and expectations are fading that a new fiscal stimulus package will be passed. Mega-cap stocks outperformed the S&P 500 last week, but Microsoft, Apple, Netflix, Amazon and Facebook are all still down for the month. Small-cap and cyclical stocks were hardest hit by the news that a vaccine is further away than initially thought. Ruth Bader Ginsburg’s death has ushered in fears that stimulus talks between Republicans and Democrats could be overshadowed by a political battle for a Supreme Court nominee. A surge in coronavirus cases in Europe has also seen investors shun some European stocks on fears that economic restrictions could be reestablished.
September Woes Continue; Three Key Concerns and Our Views
For the first time after a powerful six-month rally the S&P 500 flirted with a 10% correction, the largest pullback since stocks bottomed in March. Here are three key concerns that triggered the decline and our thoughts on why these worries present near-term roadblocks, but do not necessarily signal a broader change in the direction of the economic and market recovery.
1. Excessive valuations
Entering September, the S&P 500’s valuation, as measured by the price-to-forward-earnings ratio, was the priciest since late 1999 – early 2000 (23 times earnings versus the historical average of 16 times). A key contributor to the market pullback has been weakness in mega-cap technology stocks, which led the market higher earlier this year, and which carry an outsized weight on major indexes. Between January and August, the average return of the FAANGM stocks (Facebook, Apple, Amazon, Netflix, Google and Microsoft) was almost 54% higher compared with a 4% average decline for the other 495 stocks in the index. This trend reversed in September, with the prior leaders recently becoming laggards (the average FAANGM stock declined 12% vs. a 5% decline for the other 495 stocks)1. The combination of elevated valuations and weakness in tech has led some investors to draw similarities to the 2000 tech bubble.
We believe that valuations are full but are not excessive, given record-low yields and expectations for corporate earnings to improve. While expanded valuations provide little margin for error, there are some key differences between today’s environment and the late ’90s that led to the burst of the tech bubble.
Interest rates are structurally lower now and likely to remain low for an extended period. The 10-year Treasury yield is currently at 0.7%, a far cry from the 6% level that government bonds were yielding in 20001. Moreover, between 1999 and the first half of 2000, the Fed was tightening policy by hiking rates at a steady pace, which triggered the eventual burst of the bubble. In contrast today, the policy interest rate is near zero, with the Fed signaling that it does not expect to raise rates until the end of 2023. There is no clear answer on how much future earnings, a public company, or the market in general are worth when the cost of capital, or required rate of return, is almost zero, but our sense is that investors are willing to pay more than they would have if interest rates were higher.
The economy is currently in the process of exiting a severe recession, rather than entering one like in 2000. As a result, corporate earnings have likely bottomed and are expected to recover heading into next year, which should help valuations improve. In contrast, during the tech bubble sentiment and valuations were expanding at the same time as earnings were peaking.
Lastly, today’s mega-cap technology companies are more mature, highly profitable companies, with little debt on their balance sheets.
2. Lack of additional stimulus to bolster recovery
The passing of Supreme Court Justice Ginsburg raised concerns that a partisan fight over a SCOTUS nominee could distract from ongoing negotiations between Democrats and Republicans on a deal for another fiscal-relief package. Investors reacted negatively to the news, as a stalemate poses a threat to the emerging recovery.
The progress of the economic recovery will be slower in the absence of another round of fiscal support. The combination of extensive central-bank and government support have undoubtedly been critical components of the rebound in the economy and the markets. With monetary policy approaching its limits, government spending must shoulder the burden of bridging the income and employment gaps until the economic effects of the pandemic fade.
However, the absence or delay of another round of fiscal relief doesn’t have to reverse the progress already made. The larger-in-size injection of stimulus administered earlier, when the economy needed it the most, is still showing some of its benefits. The U.S. personal saving rate, or savings as a percentage of disposable income, remains elevated (18% vs. the 9% historical average over the last 70 years), even as previous relief measures have expired. This extra buffer could support spending in the coming months while the labor market continues to heal2.
Lastly, a deal for further relief is still likely, as both sides agree on the need for more spending to offset the hit to incomes from the pandemic.
3. Ongoing health worries make a V-shaped recovery elusive
Adding to the negative sentiment last week were renewed fears that a second wave of coronavirus cases in Europe will lead to more restrictions. An unexpected decline in the September preliminary reading of European economic activity for the services sector also reminded investors that important constraints on the recovery remain.
The root cause of last week’s pullback in stocks was, in our opinion, the recalibration of lofty expectations about the pace of the recovery. We maintain the view that after the initial sharp snapback in activity experienced in the summer months, the recovery has entered a new phase in which growth will be slower with periodic setbacks along the way.
Absent a faster-than-expected distribution of an effective vaccine (current consensus assumes mid-2021), growth across sectors will stay uneven, preventing a full V-shaped recovery. For example, demand has shifted from services to goods, boosting retail sales above pre-pandemic highs. Housing continues to be a standout, with existing and new home sales surging to levels not seen since 2006. On the flip side, small-business revenue is 21% lower, and spending on restaurants and hotels is 25% lower compared with January levels3.
Positively, a scenario of slow growth and gradual recovery does not have to translate to lackluster returns for investors, as the last economic expansion demonstrates. Following the Great Financial Crisis in 2008, the speed of the expansion was the slowest in the last 70 years. GDP was growing a little over 2% a year, with retail sales taking two years to return to pre-crisis levels and industrial production taking five2. Yet, this U-shaped recovery still produced decent outcomes for investors, but with periodic pullbacks.
What to expect from here
We believe the newly emerging bull market will prove durable, but not without growth scares and setbacks, as the range of economic outcomes remains wide (though narrower than in the spring). Following a powerful six-month rally, returns will likely slow, but the gains are not necessarily exhausted, and a correction could prove healthy. While today’s environment is unique, it is helpful to gauge the range of historical outcomes during past early recoveries. The table below provides a historical view of the S&P 500’s performance during the first year of the rebound following bear markets and offers the following takeaways:
Corrections are common, as conditions coming out of recessions are typically wobbly.
Looking at the distribution of market gains, the bulk of gains were mostly captured in the first six months of the first year of the rebound, but returns continued to be above-average in the second half, even as the pace of gains slowed.
At this juncture, we recommend investors stay balanced and diversified but also opportunistic, deploying available cash towards long-term goals, if appropriate. As the correction plays out, lagging asset classes and sectors (including defensive areas like utilities, staples and health care) can present rebalancing opportunities to fill gaps in underrepresented areas within portfolios.
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