, ,

The Brave Report: Market Commentary for August 2020

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

The recovery rally continues to plow forward with the S&P 500 breaking into positive territory for the year. While the S&P hasn’t regained its February highs yet, the NASDAQ has risen back to all-time highs and is now up around 20% year to date.  The debate continues to rage as to whether these valuations are justifiable. This discussion is more complicated than just a multiple of earnings discussion as there are many factors at play.  While there seems to be a disconnect between stock prices and the underlying economy, that does not necessarily mean that prices for some companies are not justified at these levels.  Yes, there are definitely some names and sectors that have no business being where they are, but I would argue that there are a lot of companies that still have room to run. Recent earnings announcements have only strengthened this argument. The key moving forward will be identifying these winners while also keeping a cautious eye on the entire market as we enter the fall and the potential for new COVID restrictions becomes a reality again.

Market Overview

Over the past month, all three major indices rallied higher.  As has been a consistent trend for a while now the NASDAQ was the big winner, gaining more than 8% in July.  The S&P 500 advanced by more than 5.5% and the DOW was the laggard but still gained around 3.3%.  Based on the driving components of each index, it is not surprising that the NASDAQ and the S&P 500 continue to outperform.  Their largest components are the big tech names which seem to have weathered the COVID storm better than everyone and are poised to actually benefit from the recent environment.  The price-weighted DOW is less tech-oriented and has thus lagged.  I do not see this trend changing any time soon but with the run tech has been on there may start to be some opportunities in other sectors just based on relative valuation.

On the fixed-income side, rates continue to creep lower as the expectation for a quick economic recovery becomes more muted.  While stocks have bounced back rapidly, the injections of liquidity and the expectation that rates will remain low for a while have continued to put downward pressure on rates across the yield curve.  The 10-year treasury ended the month trading in the low .50% range which, outside of the sharp drop we saw on March 9th, is lowest it has traded.  Outside of a huge turnaround in virus numbers or a major vaccine or treatment breakthrough I expect this downward pressure to remain.

As earnings and other economic data have rolled in over the past few weeks, we have started to get a better picture of the short-term economic damage caused by the coronavirus pandemic.  I stress short term because all of this data is backward looking, and we still have a lot of unknowns looking forward.  2nd quarter GDP dropped by the most in history but is this just a temporary setback for the economy or is some of this damage permanent? I think the answer to this question depends on what happens over the next six months. Will we need to lock down the country again? What will the government do to continue to stimulate the economy and prop up small businesses? Will we get a medical solution to the pandemic? The answers to these questions will define the long-term economic fallout.

Based on the stock market performance over the past few months it seems most investors are optimistic that the long-term impact will be muted, or the government will continue to do whatever is needed to prop things up. While we wait for things to play out, the Fed has injected an unprecedented amount of liquidity into the market and has signaled multiple times that they plan to continue this accommodative policy as long as is necessary.  The President and Congress are also working to pass a new stimulus package to continue to prop up small businesses and the unemployed.  While both of these steps are much needed and are helping to support the economy until we get back to some sort of normalcy in our society, they are still just putting band-aids on a bullet hole. Many more steps will need to be taken to make sure the ripple effects of these policies don’t drag on our economy into the future.

Even with all of this government intervention, there will still be a lot of losers coming out of this pandemic, especially on the small business side of things.  PPP loans can only do so much and we have seen and will continue to see the shuttering of thousands of businesses.  On the corporate side, there will be a transformation as to how business is done. This will force most companies to adapt to survive. I expect to see a lot of consolidation throughout the corporate world as companies will need to merge in order to survive in the “new” world.  This will be most apparent in the commercial real estate, retail and travel industries.  While these types of consolidations will be painful for many, it will allow new efficiencies to be realized and force companies to better allocate their capital which in the long-term would be beneficial for business.

With the pain we are seeing in some areas of the economy, earnings data has also shown that a number of companies have greatly benefited from this crisis.  I discussed a few months ago that some companies will benefit from the changes of behavior during the pandemic but then things will go back to normal. While other companies will benefit during the pandemic and also see long-term benefits coming out of this.  This sentiment has been very apparent during earnings calls and it is showing in their stock performance.  The large tech companies are the best examples of this, and we can see this illustrated in the unprecedented outperformance of the tech-heavy NASDAQ since the crisis started.

Outside of the pandemic, there are two other big overhangs in the market right now.  Tensions with China continue to flare up and the election is looming only a few months from now.  As Trump has seen poll numbers drop he will need to do something to rally his base and create the perception of some wins going into November.  His stance on China has been one of his most popular and I expect to see continued saber rattling on this front.  We have seen the downward pressure these types of tensions can put on the markets so I will be cautiously watching any developments in this area.

Additionally, if a Biden victory becomes the de facto stance, it will be important to see who he aligns himself with over the next few months.  His big donors expect him to remain moderate, especially in financial matters but if we see the more progressive members of his party start to play a bigger role then the markets would start to look at his presidency much more cautiously.  On top of the presidential election, it will also be important to keep an eye on how the senate is trending.  With democrats already controlling the house, I expect a Biden win, coupled with the Democrats gaining control of the senate being viewed negatively by the markets.  This creates a scenario where some of the more progressive, anti-business policies have a much greater chance of becoming a reality.

Strategy Commentary

From an allocation standpoint, I made very few changes over the past month. I have rejected the urge to chase as equities have rallied and I think a period of consolidation after earnings would be very beneficial to the long-term health of the markets.  There are a lot of names that do deserve the bounce back we have seen but I remain cautious as there are still a lot of uncertainties heading into the fall.  The potential for another lockdown and uncertainties around the election put us in a position where I would rather wait before adding on the recent strength.

While I may sound like a broken record, I am still maintaining my overweight to technology. Consumer discretionary has outperformed over the past few months but I have resisted the urge to add to this position as another lockdown could add pressure to the sector.  Communication services have also outperformed but again I am maintaining my equal weight there until we get some more certainty in the economy.

I have been slowly adding back to my European exposure that I went underweight a few months ago.  I am not back to a normal weighting yet but as they seemingly have done a better job controlling the virus there could be some attractive opportunities.  This could all change if the virus spikes again but it is something I am watching closely. I have been looking to add back to some Asian, particularly Chinese, exposure but it seems that every time I do, another tension, whether domestic or with the US, creates a new level of uncertainty.  The long-term story in China is still intact and as long as you can withstand the short-term fluctuations it is a place where I want to increase exposure over time.

I did not expect rates to drop to the levels we are currently seeing, and I have continued to be neutral on fixed income.  I still have more cash than normal as a replacement for fixed income but in the current environment, having some extra cash on the sidelines seems appropriate.

0 replies

Leave a Reply

Want to join the discussion?
Feel free to contribute!

Leave a Reply

Your email address will not be published. Required fields are marked *