“What would you do if you were stuck in one place, and every day was exactly the same, and nothing that you did mattered? … That about sums it up for me.”
– Groundhog Day (1993)
We hope that this letter finds you and your loved ones well. Although it has been only three months since our last writing, it has felt like much longer. While we are gradually resuming normal operations at Biondo Investment Advisors, three long months of quarantine has left us all feeling a little like Bill Murray. Yet much like the movie, a lot has happened while we have been stuck in the same place day after day.
In the first half of the year, the S&P 500 was down roughly 4%. In a normal year, many would be asking what has gone wrong to produce such poor YTD performance. In fact, it’s not too common for the market to post even such modest losses through mid-year. But, as we all can agree, this is not a normal year. All things considered, many of us have probably taken a deep sigh of relief that market performance isn’t much worse than it is.
This relief is due to some of the best quarterly market returns in decades, led by the NASDAQ, which was up 31% during the second quarter, the best quarterly return since 1999. The S&P 500 and Dow Jones didn’t fare too shabby either, up 20% and 18%, respectively, the best in at least a couple decades.
This second quarter rally, while an upward trajectory, was very rocky with wild swings occurring even on a daily basis. Much of this choppiness came as a result of the virus news cycle, with the market focused on daily case reports, testing capabilities and both advancements and setbacks in vaccine and therapeutic development. While there have been many up and down movements in the progression of the virus, the gradual reopening of the economy has helped spur the market back upwards from the lows on March 23. A better than expected June jobs report gave hope to some that the recovery would be more rapid than initially feared.
While many of these developments are welcome news, the overall economic and public health picture is still troublesome. U.S. real GDP contracted at a seasonally adjusted annual rate of 4.8% in the first quarter of 2020, the worst outcome since the fourth quarter of 2008. The second quarter is likely to be much worse, with forecasts pointing to a real GDP decline of around 40%. While the unemployment rate ticked down from the April high of 14.7%, it sits at 11.1% as of this writing, a level that would have been unimaginable only a few short months ago. The economy added 4.8 million jobs in June, yet it is still unknown how many jobs will never come back as the economy reshapes itself from the effects of the pandemic.
The virus’s progression is still the focal point for much of the market. As we write, many states have halted or partially reversed reopening guidelines as cases spike upwards, particularly in the South. Many states have mandated wearing masks in public places and restaurants are closing again in some areas. The vaccine development, while promising, is still a late 2020 or 2021 story according to most experts. The market doesn’t seem to have fully priced in a vaccine as of yet due to this uncertain timeline. The reopening of schools in the fall is still a huge question mark.
Given all the negative news, many would wonder how the market managed this huge rally. The answer lies in a common market axiom that has proven the test of time: “Don’t fight the Fed.” Especially when they are on a mission. Make no mistake about it; this Fed is on a mission. Like Ben Bernanke during the Great Financial Crisis, Jay Powell and company are going to do everything and anything in order to prop up the economy.
There have been numerous times when the economy and the stock market were out of sync. It is a mistake to equate the two. The stock market doesn’t necessarily tell us anything about the economy, or vice versa. When the Federal Reserve pumps $5 trillion into the system, it is going to find a home. “Money goes to where it is treated best.”
It is pretty clear where it has been treated best. As we have written a few times now, recent market returns have been dominated by a select few mega cap growth companies. Currently, the 10 biggest companies represent 28.30% of the S&P 500 market capitalization, the highest percentage in modern stock market history. Excluding these 10 biggest stocks of the market, the S&P 500 would actually be down ~10%, which better reflects the long range impact of this crisis. These are led by the world’s five largest tech companies: Microsoft, Apple, Amazon, Google and Facebook.
Quite often, market recoveries are instigated by a new group of stock leaders. This time around that has not been the case. While growth outperformed value across all market cap sizes during the quarter, large-cap growth especially dominated and has outpaced large-cap value by 25% since March 31. Certainly, technology and the cloud were two giant beneficiaries of the pandemic. The prevailing leadership of large-cap growth and Tech not only has continued but accelerated.
The question now is, how much more can be expected of the expensive growth stock goliaths in pushing the indexes forward as investors wait for the recovery to gain traction? After the recent surge, the S&P 500’s P/E ratio reached 21.4x, which is significantly higher compared to the long-term P/E of 15.7x over the past 15 years. Without digging deeper, one could indeed state that the market is getting overheated. This is even more the case when we take into account the uncertain disruption of the COVID-19 pandemic on the economy in the longer term.
However, the high stock market P/E ratio is a lot lower if we exclude the biggest companies, which on average are not impacted by the crisis. The other 490 S&P 500 companies are valued at a P/E ratio of 16.9x, which is more in-line with the historical averages. The expanded outlook for the market, therefore, depends on some level of participation from these companies. So far, the market hasn’t priced in the prospects for many of these companies and industries and demonstrates the lack of visibility in the economic recovery. The impact of the virus and the shutdowns is far from being uncovered and will likely be a multi-year story.
Beyond markets being potentially overvalued, we have our share of concerns. The narrow leadership of the largest growth stocks, the shape and timing of an economic recovery, social unrest and the November elections all serve as potential reasons for caution. As such, we still have larger than usual cash reserves reflected across the strategies that we manage, albeit less than in March of this year. Should markets weaken, we will deploy cash as we see future opportunities. In the meantime, we would welcome broader participation, more signs of an improving economy and/or some resolution on the social and political fronts in order to feel less nervous about markets.
As money managers, we have emphasized the importance of holding to our investment process in environments like this. While strategically employing cash when opportunities arise, the focus has and will continue to be on holding core positions in quality companies. We are firm believers in sustainable growth companies that emphasize long-term value creation. These firms consider all stakeholders – shareholders, employees, customers and community, especially during uncertain times. These are the companies that not only generate wealth over the long run, but often come out of downturns with stronger, more dominant market positions. This methodology has served us well over time and throughout this pandemic. Much of our recent success can be attributed to actions taken well before these recent events.
As always, we value the trust you have placed in us, particularly during these periods of uncertainty. While we can’t predict when this will be all over, we can say for certain this too shall pass. We look forward to the days of seeing you all again and to continued peace and prosperity.
Scott A. Goginsky, CFA®
Sources: Seeking Alpha, CNBC
The information set forth regarding investments was obtained from sources that we believe reliable but we do not guarantee its accuracy or completeness. Neither the information nor opinion expressed constitutes a solicitation by us of the purchase or sale of any securities. Past performance does not guarantee future results.