The first half of 2020 was a real doozy. After a gut-wrenching freefall into the fastest bear market decline in history in the first quarter as the COVID-19 pandemic unfolded, the stock market seemed to defy logic by turning on a dime and delivering one of the strongest rallies in nearly 100 years from its late March low. While certainly a welcome reprieve for investors who were still reeling from the market’s collapse, it also left even the most grizzled market participants scratching their heads and trying to make sense of the moves.
By the end of the quarter, the S&P 500 Index (including dividends) had recovered to a loss of just -3.2% on the year by posting its best quarter since 1998 with a gain of 20.2%. Developed international equities weren’t far behind, gaining more than 15%. Diversified commodities also gained, but gold was the clear winner within that asset class with a gain of 14%. Bonds managed to deliver modest gains, mostly thanks to corporate credit outperforming. Treasury bonds were flat, with the 10-year Treasury yielding a paltry 0.65%.
The Big Reopening
The stock market rally was driven largely by signs that the U.S. economy was beginning the process of reopening from a virtual standstill. It may seem like a distant memory considering how things have backtracked as the third quarter gets underway, but the U.S. was able to “bend the curve” lower in terms of slowing the rate of new infections beginning in early April. According to data from the Johns Hopkins Coronavirus Resource Center, infections peaked at just under 35,000 per day based on a 7-day average on April 9th, and began a slow but steady decline from there. This allowed states to start to lift stringent restrictions that were put in place to slow the spread of the coronavirus. From late April and into early May, stay at home orders were either lifted or eased in many states around the country.
By that point, economists were braced for a disastrous downturn but were hampered by a lack of visibility due to most major economic data being reported on a lag. Instead, they began to focus on alternative but more timely sources of data, including restaurant reservation activity as measured by Open Table, airport travelers passing through TSA checkpoints, and mobility data collected through smartphone usage by Apple and Google. All of these reflected a sudden collapse in the economy, but being more real-time they also were the first to indicate the faintest signs of a pulse as the economy began to slowly reopen in parts of the country. For instance, data tracked by Open Table showed that the number of seated diners at U.S. restaurants measured on a year-over-year basis utterly collapsed from flat growth on March 8th to nearly -100% by March 20, as restaurant shutdowns were imposed across the country. This largely remained the case until the beginning of May, when it began to slowly creep higher, and by the end of the quarter this data showed the number of diners had “improved” to -62.5% year over year. While still an awful environment for the restaurant industry, it did show things were starting to head in the right direction.
As the situation stands today, there remains debate about the ultimate shape of the economic rebound—whether it will snap back quickly in a V-shape, or proceed less rapidly in more of a U or W pattern. However, there’s no denying that at least for the second quarter, the underlying trend in economic data was one of steady improvement, albeit from very depressed levels in many cases. Initially, this was apparent in the aforementioned alternative data sources, as well as some traditional survey-based indicators that were viewed skeptically since they didn’t reflect “hard” or actual data, such as the monthly Purchasing Manager’s Indexes that ask a sample of manufacturing companies if business improved or not compared to the prior month. But the most unexpected and concrete example of economic healing arrived on June 5 with the monthly employment report, which showed that there was a job gain of 2.5 million in May, which far surpassed the official consensus expectation of a loss of 8 million jobs. The sudden restart of the economy and subsequent broad improvement in economic data was also captured in the Citigroup Economic Surprise Index, which is designed to gauge whether economic data turns out to be better or worse than official economist forecasts. This indicator sank to a near record low of -145 on April 30th as economists scrambled to revise their estimates lower, but has since surged to a record high of +181 by the end of the quarter, which underscores that they grew overly pessimistic even as data started picking up.
However, complicating all of this is that on June 8, the Business Cycle Dating Committee of the National Bureau of Economic Research, which is the official arbiter of business cycles in the U.S., officially declared that the economy peaked in February, meaning that a recession began in March. This was actually one of the quickest decisions that they’ve made, which is often determined on a considerable lag. But the severity of this particular downturn sped up that process. The big question now is, could this end up being the shortest duration recession on record? Currently, the shortest is the 1980 recession that lasted six months. Based on the degree of economic improvement over the past few months, it’s possible that the trough of this recession is determined to have been reached in May, meaning it would be the shortest on record by far in lasting only two months. Whether this turns out to be the case or not will depend on whether the current rebound can sustain over the remainder of the year. But there seems to be a good chance that the trough of the recession has passed, especially when factoring in the tremendous amount of fiscal and monetary stimulus that’s been marshaled over the past few months—as long as the country can avoid another full shutdown.
Are We in a New Bull Market?
Considering everything that’s happened over the past few months, in some ways it’s hard to believe that the S&P 500 was down by just -3.2% for the year at the end of the quarter. The market has experienced a stunning rally of 38.9% from its low on March 23rd. With the common definition of a bull market being an increase of 20% from a recent low, which the S&P 500 hit back on April 8th, it’s naturally raised the question of whether or not we’ve already entered a new bull market? To some, that may seem preposterous considering the current state of the economy and the ongoing pandemic. Others are quick to point to the fact that prior bear markets did experience large countertrend rallies that ultimately failed. But it’s important to consider that bull markets are born of investor despair, and often take hold when an economic downturn is at its nadir.
There is concern related to recent gains being increasingly led by a small group of large cap Growth stocks that belong primarily to the Technology, Consumer Discretionary, and Communication Services sectors. An index of the so-called FANG+ stocks (Facebook, Apple, Netflix, Google, Amazon, Microsoft) has gained 25% through the end of the second quarter, compared to a loss of -6.5% for the remaining 494 companies in the S&P 500. That’s certainly a wide disparity, and does raise some questions regarding whether the current rally is sufficiently broad enough to sustain further gains.
However, although there may be some frothiness building in those stocks, there’s other evidence showing that the gains from the March 23rd bottom have been widespread. For starters, all 11 sectors of the S&P 500 Index have risen by more than 20% since then. In addition, the strength and size of the move off the bottom has triggered several different technical indicators that are designed to measure “thrusts,” which often occurs in the early stages of a bull market and have reliably forecasted additional gains over the next six to twelve months. Lastly, the character of the rally so far actually compares favorably to the initial stages of major bull markets that began in 1982 and 2009, as Jim Paulsen of the Leuthold Group recently pointed out. He noted that not only are they tracking closely together in terms of the magnitude of the gains at this point, but those two bull markets were launched in the wake of very severe economic downturns, as is this case this time, too.
In light of the economic improvement and possibility of being in a new bull market, Pinnacle’s Dynamic Prime portfolios were gradually repositioned from a defensive posture to neutral from an overall risk standpoint by the end of the quarter. This involved a combination of purchasing cyclical U.S. equity sectors, international equities, gold, and corporate credit within fixed income. Overall, portfolios are tilted towards cyclical Growth equity sectors that tend to benefit in low growth and low inflation environments, with a corresponding underweight to cyclical Value sectors. Within commodities, we continue to carry an overweight to gold and actually added to that during the quarter. We believe that the current environment is very conducive for gold to continue to perform well, with interest rates so low that they’re actually negative on an inflation-adjusted basis and plenty of liquidity being provided by central banks around the world.
We’re now closely watching the behavior of the U.S. dollar, which has started to weaken. If the dollar fell significantly from here, it could have several implications for security selection within portfolios, potentially boosting the attractiveness of cyclical Value sectors and international equities.
As the quarter drew to a close, risks to the market outlook seemed to be on the rise again. New infections stopped falling and began surging in parts of the country, reaching a new record high of more than 45,000 per day by the end of the quarter. Some states were reluctantly moving towards imposing new restrictions on certain activities in what seemed like a replay of March and April. In addition, investors are also bracing for second quarter earnings season which is just about to get underway. Expectations are very low, with current estimates predicting a -45% contraction on a year over year basis. Perhaps more importantly, in the first quarter, many companies withdrew future guidance due to the amount of uncertainty created by the pandemic. What these companies are willing to disclose this quarter in terms of their assessment of business conditions going forward will be closely watched. And last but not least, the November election is now less than four months away, with current polling data suggesting that there’s an increasing possibility there will be a change in leadership. A lot can happen between now and November so it’s too early to have a high degree of confidence in the outcome, but a potential risk to the market is that a new administration would likely implement a very different economic policy backed in part by higher taxes. All of which leads to the question: Is this recovery for real? Or were the past couple of months a temporary reprieve that’s destined to falter?
While there are certainly risks looking ahead, and the recovery is bound to be uneven, we do believe that the worst is behind us and that the trajectory should remain up—assuming that the recent spike in the number of cases of the virus doesn’t result in another complete shutdown of the economy. Unfortunately, COVID-19 will remain a part of life until a vaccine is eventually available, but in some ways the country is better prepared to manage this compared to the initial outbreak in March (based on medical advances since then as well as social distancing measures that can make a real difference in slowing the spread when properly followed). In addition, a potential silver lining to the economic downturn is that it’s created a significant amount of slack in the economy, which should prevent inflation from picking up meaningfully anytime soon; that will allow the Fed to maintain a highly accommodative monetary policy for an extended period of time. Indeed, Fed Chair Jay Powell recently claimed that they’re “not even thinking about thinking about raising rates.”
In addition, there’s a strong possibility of another round of fiscal stimulus being enacted in the coming weeks that’s projected to be about $1 trillion, which should provide additional support to both consumers and businesses with emergency unemployment benefits currently scheduled to run out on July 31.
In our view, there has been enough improvement in both the economy and financial markets to be positioned at a neutral level of risk in client portfolios. Volatility is likely to remain elevated until there’s more clarity about future business conditions, as well as on the medical front with developments in COVID-19 treatments (or even a vaccine) that would give consumers the confidence to resume normal activities. In the meantime, we will continue to diligently monitor incoming data, and continue to look for investment opportunities that exist in a challenging environment.
Pinnacle Advisory Group, Inc. (“Pinnacle”) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where Pinnacle and its representatives are properly licensed or exempt from licensure.
The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.