Approaching volatility may present opportunities for investors to add to their portfolios in favored areas. Hear more from Mike Gibbs, managing director, and Joey Madere, CFA, senior portfolio analyst, both of the Equity Portfolio & Technical Strategy group.
Following one of the worst quarterly performances in history in the first quarter of 2020, the S&P 500 staged a remarkable rally during the second quarter. Importantly, powerful surges in performance out of recessionary bear markets have historically been indicative of further strength and above-average returns over the next 12 months. Fueling the rally has been enormous fiscal and monetary stimulus (with more likely to come), as policy makers attempt to support the economy and reduce credit concerns.
As the economy restarts, numerous early economic readings are moving ahead of expectations, buoying investor sentiment toward the recovery process. This will be important to monitor as we believe the trajectory of the recovery will be paramount to investors as we move into the back half of the year. Still, the virus spread remains a central influence on the equity markets. We are encouraged by the promising medical data on treatments and the potential for a vaccine, as they can have material impacts on consumer behavior and the pace of the economic recovery. However, we are also mindful of the potential for pockets of outbreaks as the economy reopens, though we believe the bar is high for state-wide shutdowns again and more likely there will be slower reopenings.
As if the virus spread has not created enough uncertainty for the market outlook, investors must also prepare for an upcoming presidential election, along with the likelihood of US/China trade rhetoric ramping up over time. As for the election, the odds of a Democratic sweep are rising, and we view this as a risk to the equity market as Biden has stated his intent to raise corporate taxes to 28% (from 21% now), along with other tax changes. We would not become overly concerned with this right now, as a lot can change by November and Biden’s tax proposal would likely not come into play before 2022. Nevertheless, a Democratic sweep would be a headwind to fundamentals if it were to take shape over time. With so much uncertainty around influential variables, we believe there is bound to be increased volatility in the months ahead. However, we believe the positives (namely unprecedented stimulus) outweigh the potential negatives. As such, we would use those volatile periods as opportunities to accumulate favored areas for the long-term bull market opportunity that remains. Remember, bear markets are often short and violent, whereas bull markets typically last for years. So while the S&P 500’s ascent from the March lows has been remarkable, on average, bull markets have spanned 1,233 days and seen price gains of 155%.
Fundamentally, the earnings outlook is beginning to improve, and record low interest rates (and very low inflation) make the S&P 500’s current price-to-earnings multiple of 21x justifiable. In our view, valuations can stay elevated given the enormous stimulus, the likelihood that interest rates stay lower for longer, no current threat of inflation, and no attractive alternative to equities. For example, the equity risk premium (the difference in S&P 500 earnings yield and the US 10-year Treasury yield) is still at 4% following the market’s rally. This remains over one standard deviation above the long-term average, and the S&P 500 forward 3-year return has never been negative following a 4% or higher reading. Additionally, the S&P 500’s dividend yield (1.84%) remains over 1% above the US 10-year Treasury yield (~0.70%), keeping it at its highest relative value on record versus bond yields.
Our favored sectors are Technology, Health Care, Communication Services, and Consumer Discretionary. The Technology-oriented and Health Care stocks have been able to outperform in the current environment, benefitting from much more stable earnings streams and relatively strong fundamental momentum. Also, on the other side of the recovery, Technology likely continues to benefit from the accelerated transformation to a digital economy, Communication Services benefits from increased broadband demands and content, and Health Care benefits from increased focus and spending by both the government and individuals. Consumer Discretionary is our newest favored sector, recently upgraded to an overweight recommendation as we believe investors should be adding some exposure to the more cyclical areas that have more leverage to the economic recovery. Additionally, there are many dynamic consumer companies operating well through the pandemic due to improved online capabilities, while the others will have room to catch up as the economy normalizes over time.
Similarly, large caps benefitted drastically versus small caps in the downturn due to generally more stable balance sheets and business models. Small caps have more volatile earnings streams and, in turn, more volatile performance. However, they also have the ability to achieve outsized gains as the economy normalizes. While global economic activity has deteriorated since late 2018 (as trade tensions rose), small caps have underperformed drastically versus large caps, giving back roughly ten years’ worth of previous outperformance in the past two years. As the global economy restarts, we believe small-cap relative performance should benefit in the months ahead from the improvement in activity. In fact, small-cap relative performance has generally moved with manufacturing trends over the past ten years. With manufacturing data bouncing off of the bottom, this stands to become a tailwind to future performance. As such, we would be preparing to build positions in small caps during the months ahead if there are no set-backs in the economic recovery.
Finally, in terms of global positioning, the US remains our favored region. However, we do believe tactical global asset allocators should be closely monitoring both emerging and international markets. The risk-on move in global markets has pushed the US dollar sharply lower, breaking down technically. Should the US dollar trend lower (as it did coming out of the past two recessions in 2003 and 2009) on improving global economic data, the emerging markets likely stand to benefit given more leverage to the global economy and an 86% inverse correlation between the US dollar and relative performance of the emerging markets over the past ten years. Additionally, international markets will likely see a boost due to large stimulus, with the European Central Bank recently injecting liquidity into the system following the Bank of Japan’s stimulus. Both Europe and Japan continue to face long-term structural headwinds, therefore current positioning is tactical only.
In sum: We believe equities are in the early stages of a bull market. Record low interest rates and unprecedented global stimulus are likely to fuel the economic recovery and result in elevated valuations. While volatility is bound to happen in the months ahead due to vast uncertainty surrounding the virus, geopolitical tensions, and the election, we believe the positives outweigh the potential negatives. Accordingly, we would be buyers on pullbacks and position portfolios toward the long-term bull market opportunity that remains.
All expressions of opinion reflect the judgment of Raymond James & Associates, Inc., and are subject to change. Past performance may not be indicative of future results. The performance noted does not include fees and charges which an investor would incur. Investing in international securities involves additional risks such as currency fluctuations, differing financial accounting standards, and possible political and economic instability. These risks are greater in emerging markets. Small cap securities generally involve greater risks and are not suitable for all investors. Companies engaged in businesses related to a specific sector are subject to fierce competition and their products and services may be subject to rapid obsolescence. Asset allocation does not guarantee a profit nor protect against loss. Dividends are not guaranteed and will fluctuate.