The stock market has done the one thing nearly all the pundits said was impossible: making a V-shaped recovery. The stock market, as measured by the S&P 500, has soared nearly 40% since the apparent bottom, March 23. The market is now up on a year over year basis and is down only about 6% year to date.
Yet, the economic and medical prospects are, at best, dicey. On the medical front, over 106,000 Americans have died from this pandemic, as cases have topped 1.8 million. There is no vaccine that people can now take to defend against infection. Therapeutics are not yet available to prevent death. All Americans who want to be tested cannot yet be tested.
On the economic front, this coming Friday, June 5th, the government is expected to report that nearly 20% are unemployed, a figure not topped since the Great Depression. By all accounts, we are in a recession, meaning a negative GDP print for two quarters in a row, with the latest report on the First Quarter indicating a 5% decline and speculation that the Second Quarter will come in about -17%.
Is it possible to reconcile the fundamentals and the recent market action? After all, why is the market less than 10% from an all-time high when nearly one in five Americans is out of work? While the knee-jerk reaction is to say that the market is grossly overvalued and out of touch with economic reality, there are several important reasons why the market may reflect the current state of affairs.
First, stocks are discounting mechanisms. They look forward, not back, and the outlook is improving. On the medical front, the so-called curve of Covid-19 cases is flattening. Activities initially forbidden are gradually being allowed to start up again in all 50 states. There are positive developments on vaccines, therapeutics, and testing availability.
On the economic front, it is assumed that as the Covid-19 pandemic lessens, economic activity will start back up. For stocks, the important GDP and employment statistics are not the current ones but the those to be reported in the second half of this year and beyond. Indeed, for a market that’s trading at 20 times next year’s earnings, the earnings for the next 20 years are relevant.
The other way to reconcile recent stock market action is to recognize that it’s really a tale of two markets. One market is the hot stay at home plays, ranging from cleaning supplies, to pizza delivery companies, to tech plays that increase productivity for those working at home. For example, Domino’s Pizza (DPZ) is up 32% this year, Clorox (CLX) +36%, and Amazon (AMZN) +32%.
The other market is smaller stocks, industrials, travel and leisure, financials, energy. The Russell 2000 ETF (IWM), a small cap barometer, is down 16% this year, US Global Jets ETF (JETS), a fund of airlines, is off 52%, SPDR Financial ETF (XLF), a fund of S&P 500 financial stocks, has declined 23%, while SPDR Industrials (XLI), a fund of S&P 500 industrial stocks, is off 16%.
Bottom line, investors in the latter grouping of stock see much less of a disconnect between the ugly economic and medical headlines and the performance of that portion of the market.
Investment Game Plan
Our bottom line is that there is still money to be made in stocks, that diversification is critical, and that an allocation to fixed income makes sense despite the low interest rates.
Investors must be very mindful of their overall financial situation. A carefully crafted asset allocation is critical. If there’s been a job loss or health setback, whether due to Covid-19 or otherwise, it may be time to de-risk that asset allocation. On the other hand, speculation about the market outlook should not give rise to de-risking an asset allocation simply because you’re six months older. Your asset allocation should have already contemplated the passage of time.
The reason for optimism is grounded on the inevitability of positive developments on the health front. Expect improving consumer spending as self-quarantining relaxes and pent up demand appears. At the same time, policymakers are likely to keep interest rates pinned to record lows while continuing to spend to help the most vulnerable areas of the economy, including laid off workers, small businesses and hard-hit state and local governments.
The bearish case rests on the much feared second wave, meaning a resurgence of Covid-19 when temperatures dip next fall. The economy’s current reopening may be reversed if it produces too many new virus cases. Even with reopening, consumers may be fearful of engaging and leaving their homes. Healthcare developments may be delayed and the much sought after vaccine may in fact never arrive.
Medical Developments Key
We believe a vaccine will be the most important development. Biotech Moderna (MRNA) has had encouraging results with a very small group of patients. The US Government has awarded $1 billion to a partnership of Astrazeneca (AZN) and Oxford. Merck (MRK) has three different vaccine initiatives. Many believe a vaccine will be the magic bullet to provide peace of mind.
Testing is becoming more widespread and available. Certainly, if it becomes as available as weapon screening at an airport, that could give the public great assurances about entering various venues.
Therapeutics that could keep Covid-19 from possibly becoming a death sentence would be a game changer. Gilead (GILD) is developing such a drug under the name Remdesivir.
State Reopenings Set the Tone
All 50 states are relaxing stay at home requirements and reopening commerce to some degree. Watch for any resurgence in cases and the possibility of a reclosing. There remains a big debate as to the goals of the closures, whether to simply keep hospital facilities from being overwhelmed or to stamp out incidences of the virus.
The confidence of the American consumer, both in the state of the economy and for their physical wellbeing, is critical. Various surveys suggest that Americans are becoming increasingly concerned about the health of their pocketbook as well as their physical wellbeing. This suggests that the public may well tolerate some uptick in cases following reopening.
The Federal Reserve
We have never seen a Federal Reserve more committed to using all the tools at its disposal. Not only has it pinned short term interest rates at zero, but it has for the first time ever bought investment grade and even junk rated debt. The Federal Reserve now owns some $1.3 trillion in exchange traded funds. Could equity exchange traded funds be next if needed? That has happened in Switzerland and Japan.
This, too, has been unprecedented. Nearly $3 trillion has been unleashed and we think there’s more to come. State and local governments desperately need assistance although there’s some pushback as some lawmakers don’t want aid to address budgetary shortfalls that pre-dated Covid-19. A fair point, but this is an election year, inflation and concern about the deficit is a no-show, so we are likely to see more aid packages being passed.
Investors must take a long-term approach. Risks abound. Valuations are stretched and leave markets vulnerable to a correction or worse. There is a huge market cap concentration at the very top of the S&P 500. For example, Apple (AAPL) and Microsoft (MSFT) together have a bigger value than the entire index of small caps, the Russell 2000. While price to earnings ratios are less than during the Dot-Com bubble of the late 1990s, price to sales ratios do approach that period. A decrease in profit margins as the behemoths compete against each other or come under government scrutiny could bring prices down dramatically.
The much feared second wave could trigger another lock down like we saw earlier this year. It is very hard to handicap that, but the second time with anything at least means we have a game plan ready. That may be far enough off to allow time for medical developments to be better percolated.
There is the usual litany of other possibilities to worry about. Tension could further escalate with China. Interest rates could start to rise, siphoning off investment dollars and making fixed income more attractive. Policymakers could make an error, cutting off the green shoots. Inflation or worse could make an appearance given the ballooning deficits and spending. Although unlikely, you can’t guarantee that some state and or local government doesn’t default on debt, lay off workers, and or become a major drag on the economy.
Focus on market leadership, strong balance sheets, dividend payouts and the opportunity for their growth in sectors that are not in favor now but have good long-term potential.
Energy: Chevron (CVX)
Energy has been the worst performing sector for the last decade as fossil fuel prices have collapsed. However, as they say, the best cure for low prices is, well, low prices. The energy sector has been the top performing group since the market low on March 23, up nearly 60%. Chevron is the most praised of the integrated oil names, regularly prioritizing and increasing its dividend, now over 5.6%. It boasts top refining assets and key properties in the Permian basin, plus strategic holding overseas.
Financials: PNC (PNC)
Financial stocks have been major laggards. Their core business of lending has had its margins crushed due to the very low Fed engineered interest rates. Meanwhile, they have forecast that their loan books are worth much less as fears over the economy trigger skepticism as to the whether some of the loans will be repaid. However, the stocks are very cheap, below book value in many instances. PNC recently sold its holdings in Blackrock (BRK) for cash, so now 1/3 of the value of the company, the 7th largest in the US, is in cash. This makes it easy to honor or increase its dividend, buy back stock or shop for acquisitions. The stock was over $160 in December and is now just over $114, with a 4% dividend.
Industrials: Boeing (BA)
Boeing is America’s largest exporter and manufacturer, with a stock price now cut by 2/3 due to its exposure to a very quiet airline business and travails over the 737 Max. However, it still benefits from its defense and space business, while air traffic is starting to perk up. While any one airline may fail, people will still travel. The nation’s air fleet is old and needs to be upgraded, perhaps to models that have more social distancing. The recent Pakistani crash involved Airbus, so at least it underscores that the current duopoly should not become a monopoly.
Consumer Staples: Coca Cola (KO)
A low risk way to play a gradual reopening is with Coke. While more has been consumed at home than before, it has not been enough to offset the loss of business in away from home venues, like restaurants and bars. That will return. Plus, you have exposure to bottled water and other beverages, plus to hard hit areas outside the US. If the Dollar weakens a bit that too will help. While you wait enjoy the robust dividend (3.5%).
DG Dietze and his family and or Point View clients own CVX, PNC, BA, and or KO.
Note: David Dietze is President and Chief Investment Strategist at Point View Wealth Management.
Point View Wealth Management is an SEC-registered investment adviser and part of Peapack Private Wealth Management. For over 25 years, Point View Wealth Management has been providing customized portfolio management services and comprehensive financial planning solutions for individuals and their families to develop and achieve their financial goals.
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