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The Brave Report: Market Commentary for May 2020

Click here for .pdf version of this report: The Brave Report-May 2020

The stock market is not the economy….at least not always. The country is shut down. Businesses are closed and unemployment claims are reaching levels never seen in history. Yet the stock market just completed its best month in more than 30 years and one of its best months in history.  On the surface, these two vastly different pictures do not seem to make much sense. While we have seen some states start to open up a little, we are still a long way from normal. Until we have a viable treatment or a vaccine, the fear surrounding this pandemic will be woven into all facets of our lives for many months or even years to come. Yet, we have seen one of the fastest stock market recoveries in history. All the major indices are still down substantially since this crisis hit but we are well of the lows we saw in March.  So, the questions remain; How can the economy look so bad and the stock market be performing so well? And is this bounce back in the market justified?

Market Overview

The markets bounced back sharply during the month of April. Following one of the worst months in history in March, all major indices saw one of their best months in history in April.  The Nasdaq outperformed, jumping close to 15% during the month bringing its year to date performance close to flat for the year.  The S&P 500 and Dow Industrials jumped 12.7% and 9.7% respectively but both remain down more than 10% for the year.  The tech-heavy Nasdaq was propped up by its largest names who have held up better during this recent market turmoil. Its 4 largest components are all positive on the year with Amazon up more than 30% and Microsoft up more than 10% (as of the end of April). This outperformance of a few large names, which are the largest contributors to index performance, has helped to mask the real carnage that is going on in most of the market.

On the fixed-income side, we finally saw some stability in rates.  After record-setting volatility in March, we saw rates settle into a relative trading zone for most of the month.  During the last two weeks of April, we saw the 10-year treasury trade in just a 10-basis point range, finally settling around .60% to close the month. For reference, the 10-year traded in a 90-basis point range during the month of March.  With the Fed maintaining overnight rates at 0%, I do not expect too much movement in the short run.  I do not see them moving to negative rates and without a major positive shock to the fundamentals of the economy I see no reason that rates will increase any time soon either.

Throughout this crisis, I have received a lot of questions from clients, prospects and friends.  Recently these questions have all echoed the same sentiment. How can the markets be bouncing back so much when the economy looks so bad?  I agree that there is a disconnect between what we are currently seeing in the markets and what we are seeing in the economy, but I would also argue that we are not too far off from a fair valuation. The trip we took to get here is the irrational part of the equation and not the actual market level we are currently sitting at.

The important thing to remember about the stock market is that stock prices are not a representation of company performance yesterday or even today. Stock prices are a representation of future cash flows of a company. Those cash flows go well out into the future so there will often be a disconnect between market performance and current economic performance.  Therefore, expectations of future economic performance hold much more weight than what we are seeing today.  A recent example of this can be seen just back in February when the crisis hit.  The economic data was still coming in strong. Unemployment was still low and GDP growth was actually revised up. However, the market dropped sharply based on the expectation that the pandemic would have a huge negative impact on the economy, which it has. In February, the same argument could have been made that the market was not trading in line with economic performance, just in the other direction than we are seeing today.

Now, as we are in the peak of economic negativity the market is rebounding based on the expectation of improved economic performance.  We are seeing progress on the health side as the curve is flattening in some areas and some treatments are showing efficacy. Some states have chosen to start opening up their economies and we have seen the government throw unprecedented amounts of money at the problem.  With all these things considered, the expectation is that the economy will start to improve. Thus, investors have started buying stocks again, driving prices higher, even in the face of dire economic news. This is not irrational as many have questioned but rather in line with the fundamentals of stock pricing.

The other variable at play here is the emotional side of investing. In times of panic and euphoria, we often see outsized moves up and down.  In this case, when the pandemic hit, we saw panic selling drive prices far below where they should have gone.  As the news changed and the outlook became more positive, not only did we have to factor in the good news, but we had to make up for the overshoot to the downside first. This caused the recovery to look that much more impressive. Now that we have seen the overshoot to the downside and the rapid recovery back up I think the markets are now in a situation of figuring out where fair value really is.  In the absence of any other positive or negative shocks to the system, I think a period of consolidation would be beneficial to the markets.  We can remove the emotion from the markets and start investing based on fundamentals again. This will give markets the chance to really parse out the actual economic impact of the pandemic.

If we forget about the path we took to get here and just look at where we are as a point in time than it is much easier to make a rational assessment of where we are and if we are over or undervalued.  Last year the S&P 500 had total earnings of around $140. Analysts are currently projecting that earnings will drop by 17.8% this year. If that projection holds true, then earnings will be right back where they were in January 2018 ($115). Interestingly, at current levels, the S&P 500 is trading at the same market level that it was in…January 2018. However, the difference is that there is an expectation that earnings rebound back to where they were this past year within a few quarters, especially if you factor in the unprecedented fiscal and monetary policy that the government has implemented. If this is the case, then the argument can be made that the market is actually undervalued as compared to January 2018 since those expected future cash flows will be higher than they were in January 2018. Now, whether the markets were fairly valued in January 2018 is a discussion for a different day, but it helps to put into perspective the current valuations of the markets and whether we have bounced back too quickly

What to do now? It’s now time to move past the initial drop and pop of the crisis and determine how to best be positioned moving forward. A lot of the initial emotional reactions are behind us and we can now more clearly define the winners and losers of this pandemic.  More than ever, we will be in an environment where the proper sector or company allocation will have a drastic impact on investment success. While identifying who the winners and losers will be, I like to break the market down into four types of companies/sectors as an initial screen for deciding where to invest.

  1. Double Losers: The first are those companies and sectors that are being hurt by the immediate impact of the economic shutdown and will also see long-term or lingering negative impacts on their business models moving forward.  These companies are being hurt drastically now and it will be years till they recover to post-crisis levels if they do at all. The most obvious examples in this group are those companies in the travel sector and brick and mortar retail.  Not only is their revenue almost zero during the pandemic but long-term habits will be forever changed coming out of the crisis. It will take a while before leisure travel returns as individuals remain cautious about flying. Additionally, the lessons in business efficiency that will be learned from people being forced to work from home will have permanent impacts on business travel, which is the driving force of profitability for the airline and hotel industries. Over time there will be no other choice but consolidation within these sectors with only a handful of winners eventually emerging.
  2. Short-term Losers:  Second, there will be those companies and businesses that take an immediate hit from their businesses being closed but then return to business as usual once the economy is finally opened back up.  There will be short term pain but in the long run, these businesses will be fine.  There will be some consolidation as some overleveraged companies cannot survive the short-term downturn in business but for the most part the pain will be short-lived.
  3. Short term Winners: These are the companies that see a spike in business activity due to the Pandemic but then their business returns to normal.  There is nothing wrong with these companies and they may see a short-term bounce in their stock prices as investors emotionally pile in, but I would be careful with these companies.  Their long-term prospects will not have changed and like what has been discussed before, stock price is based on future earnings and not just what they can make over 1 or 2 quarters. Some of these companies will be able to leverage their short-term success enough that they become part of the final group but for the most part their long-term business models will not have changed.
  4. Double Winners: The final group is the companies you want to focus on as you look to invest during and coming out of the pandemic.  These are the companies that are seeing a surge in business due to the pandemic and will also see a long-term change in their businesses in the post Covid world.  They will also hold up the best if the pandemic lingers or we see a 2nd wave of infections.  Some of the large tech and cloud companies would fall into this category along with companies like Amazon and other large online retailers.  For cloud companies, we have seen a surge in usage as people have been forced to work from home and a huge amount of data has been migrated to the cloud.  This surge will not be short-lived though as the efficiencies of a mobile workforce will be realized and companies of all sizes needing to be cloud-based will become the norm and not the exception. The same can be said of online retail as forced adoption during the crisis will lead to the long-term conversion of those that were tentative to shop online before.

It is important to point out that this is just an initial screening or grouping. There will be winners and losers in each of these groups and companies within each of them that are worth investing in or avoiding. This also does not factor in company strengths or weaknesses coming into the crisis such as balance sheet strength, leadership characteristics or past performance. I could write an entire report that breaks down who I think will be the real winners and losers coming out of this but that is a much longer discussion. The easiest thing to do is to ask yourself two questions:  Does this company/sector benefit from the current economic environment?  Will their long-term business model or growth rate benefit positively in a post Coronavirus world?  If you can answer yes to both questions, then you can start creating your list of companies or sectors to add to.

Strategy Commentary

As we discussed during the market drop, it can be dangerous to make many widespread allocation changes during times of such high volatility.  The same can be said when the market bounces back so fast. My overall equity exposure remained neutral over the past month.  I did slightly adjust the allocation, but the overall equity exposure has been consistent. Volatility has come down a bit over the past few weeks and as we see continued consolidation, we will reassess what damage has been done to long term allocation targets.

Domestically, I trimmed some exposure to utilities, bringing the overall exposure closer to neutral.  Utilities can act as a defensive play during risk-off environments.  As we make our way out of the crisis, I expect money to shifted away from this sector.  I did add to some selective positions as I have identified some perceived winners moving forward.  Most of these additions were in what I have been calling the modern defensive stocks.  These include many of the large, stable, tech stocks that have strong balance sheets. Their size gives them the ability to increase market share during times of turmoil.  These names performed the best during the initial market drop and I expect the same as we emerge from the crisis or see any continued weakness.

I continue to maintain my underweight to Europe for the same reasons I mentioned last month.  So far, this thesis has been playing out as expected.  Over the last month, Europe only gained 3.3%, far underperforming domestic equities.  Year to date Europe also trails, losing 22% as compared to down 10% for the S&P 500. There will be a point where valuations become too attractive to ignore in select European companies, but I think we are still a few months away from that. I am still watching select emerging markets but am mostly focused on Asia as I think we will see continued weakness in South America as the weather changes and we see a potential surge of cases in the southern hemisphere.

On the fixed-income side, I see rates staying low for the foreseeable future, but I think the risk is to the upside for rates.  There is not much more room for rates to drop and if the economy can bounce back, we will see rates rise.  I am maintaining current exposure for now.