WE ARE HERE

As the first round of the 102nd PGA Championship concluded and the sun set over the Golden Gate Bridge, ESPN announcer Scott Van Pelt closed the telecast by saying,

“It is a chore at the moment to get anywhere, to do anything. There were times this spring when this place felt further away than could be reached, but we are here.” 

In two sentences, Van Pelt succinctly summed up our current reality. At times, the last six months have felt like an eternity. As recently as March and April, it was hard to imagine we would be where we are. This said, while life is still far from normal and challenges still abound, we have come a long way. In doing so, we have learned even more.

A WILD RIDE

Back in January, the overwhelming consensus was that there was nothing on the horizon that could derail the decade-long economic expansion. Talk about not aging well. It was just the start. 

When initial reports of a virus in China surfaced, the general consensus among investors was to “hold” and “stay the course”. When it became evident that the virus had spread, calls to “de-risk” and implement “tail risk hedges” took center stage. When the virus went global, panic ensued. Dire predictions of a global depression were rampant, investors hit the eject button, and markets cratered anywhere from 30% to 50%. The once insatiable demand for venture capital and buyout funds dried up, while credit dislocation funds came back into vogue. Deal activity dried up, valuations plummeted, and yields spiked. Yet, with nearly every asset on sale, investors remained reluctant to buy. Even the vaunted Warren Buffett chose to sit this one out. Then as is so often the case, with pessimism at its nadir, the market turned. It has been rising ever since. 

Since late March, the S&P 500 is up 50%, while small caps have gained nearly 60% and the MSCI ACWI 46%. The skeptics are despondent --- How can this be happening? Doesn’t the market know we are in the midst of a pandemic?? This doesn’t make any sense! 

But what if it does make sense? What if it isn’t a mirage? What should we expect going forward?

DISSECTING 2020

Investors are perplexed, but it can be explained by a few considerations --- pandemic context, sector performance, and fiscal/monetary policy. 

First, despite its severity, a pandemic is not without precedent. Major cases include 1910 (Cholera), 1918 (Spanish Flu), 1956-1958 (Asian Flu), 1968 (Hong Kong Flu), and AIDS (starting in the early/mid 1980’s). This does not even account for the smaller epidemics over the years (SARS, MERS, H5N1, and various Ebola outbreaks). While the level of spread and severity has varied dramatically, each pandemic/epidemic shared a common trait --- they either (a) ended more quickly than expected (be it through herd immunity, a vaccine, or from a high mortality rate), (b) people learned to live with them, or (c) a combination of the two. As a result, unlike world wars, currency debasements, and financial crises where the future was completely unknowable, this current challenge is temporary. The future will undoubtedly be different, but likely at the edges. More importantly, the risks pale in comparison to what the market faced in the 1940’s (a potentially Axis-controlled world), in the 1970’s (a near complete debasement of the dollar and nuclear war), or a decade ago (a financial system in ruins). As a result, with each passing day, it appears increasingly likely that the market has simply been looking through this period knowing that an end is a matter of “when” instead of “if”. 

Secondly, focusing solely on the market’s overall performance is akin to checking a box score after an athletic event. You will learn the outcome, but little about what happened during the game. The S&P 500 is close to flat on the year, but this tells you very little. Dig a little deeper and you will notice a few key underlying trends. 

• Technology: The strong got stronger. Tech companies, cloud-focused ones in particular, held up well on the way down (-24%) and fared even better on the way out (+62% from bottom) on accelerating adoption. A lot is now priced in. 
• Energy: The weak got weaker. Fell 61% on the way down, but ironically rose even more as tech from the bottom (+65%). This said, while technology is up 24% year-to-date, energy is still down 35%. A good reminder of the math behind downside capture, as well as the potential power of opportunistically adding to distressed assets.  
• S&P 500 Sector Weights: “New World Sectors” (i.e. technology and communications) now represent more than 40% of the S&P, while “Old World Sectors” (i.e. energy, industrials, and financials) represent 20%. People have often asked how the overall market can be flat in this environment. The short answer is that when the largest part of an index performs well, it can make up for a lot of losses elsewhere. 

**Bespoke Research

In short, COVID-19 has driven the market. Technology stocks have gotten even more expensive, but with companies like Nike reporting massive acceleration in direct-to-consumer sales (the company hit their 2023 target of 30% in Q2) and countless others seeing a similar trend, this has largely been justified. Meanwhile, cheap stocks got cheaper (i.e. energy), but again...why shouldn’t they if threatened with insolvency? Today, “new world stocks” are once again priced for perfection, while the “old world stocks” are priced more sanguinely. But then again, this was the case prior to COVID as well. 

Lastly, yes...it is hard to ignore the fiscal and monetary support provided by the government and the Fed. If Hank Paulson threatened to use his “bazooka” during the financial crisis but never had to, Jay Powell and Steve Munichin took the Harry Truman approach and hit the markets with not one, but two atomic bombs. Time will tell what the longer-term implications of such actions will be, but for now they have been supportive for the market. 

THE BAROMETER

In his book Preserving Capital, John Train described the market as, 

“An index of how investors feel about the future, not the present. In other words, the market is a barometer, not a thermometer.” 

With this in mind, here we are. In the middle of a pandemic. With most Americans still working from home and the majority of children heading towards remote learning again this fall. Yet, the S&P 500 is positive on the year. Confounding, but only for those focused on the thermometer, which according to the AAII Bullish Sentiment Gauge (Bespoke Research), is most people. 

Knowing this, and in the hopes of taking the other side from the consensus, let’s instead focus for a minute on the barometer. 

First, putting aside politics, the odds are that we will be on the other side of this crisis by the end of the year (or early spring at the latest). Why? Based on the fact that nearly all flu-related pandemics and epidemics have lasted less than a year, and often considerably less. Throw in the chance of a vaccine and the chances are even higher. If so, don’t be surprised to see the bullish sentiment indicator turn higher. And hard. There are a lot of investors who have “sat this one out”. At some point these investors will feel the need to get reinvested. 

Second, focus less on the “score” (i.e. what the market is doing) and more on the game (i.e. what the underlying sectors and market capitalizations are doing). The tech sector performance provided the first clue that COVID was accelerating the future. The next clue will come from the parts of the economy that haven’t caught a bid. This likely means a narrowing in the large to small cap performance spread and a bid for “real economy stocks” that have lagged. Interestingly, given how the S&P 500 is configured (as a market cap weighted index), if this were to happen, we could very well see the bottom half of the index rally, while the overall market remains flat or even sells off given the large overweight to tech. This may already be underway. 

Lastly, keep an eye on the dollar and inflation. Betting on currencies is a fool’s errand, but their impact is nonetheless profound. As this chart from JP Morgan highlights, the US dollar tends to move in 6-9 year stretches. Given that we are currently in year 10 of a bull market in the U.S. dollar, a reversal is arguably overdue. Throw in the fact that we are experiencing a version of MMT, talking about an aggressive social spending program under a potential Biden administration, and seeing extreme pressure on the U.S. energy complex from a combination of oversupply, a lack of demand, and ESG and the set up for a weaker dollar is here. 

JP Morgan Guide to the Markets

WRAP UP

So we are here. A place few thought we would be. Looking ahead, it is hard to tell where we will be in another six months, but I can tell you this --- it is worth the effort to look beyond the box score and focus on the barometer.