The Brave Report: Market Commentary for September 2020

Click here for the .pdf version of this report:

A market divided…. The rally continued in August as we completed one of the best summers in years for the markets.  A sense of frothiness has emerged in some corners of the market as we have seen some valuations spike.  Momentum stocks and large tech names have been the driving force behind the recent market performance and seem to be all everyone is talking about in the markets.  With large technology names making up an ever-increasing percentage of the major market indices it is easy to get blinded to everything else that is going on in the markets.  Not every sector or stock is on fire and just tearing higher.  Not every sector has seen their valuations soar. It is difficult to remember a time in recent history where there was such a discrepancy in sector or style performance. The big question, is how much of this bifurcation is justified and how much is just momentum carrying some names too far too fast?

Market Overview

The markets continued their rally higher during the month of August, completing one of the best summers on record.  The DOW and the S&P 500 notched their best Augusts since the 1980s registering gains of 8.4% and 7% respectively.  The tech-heavy NASDAQ again rose even more, gaining more than 11% over the course of the month. This run in the markets has been driven primarily by the rally in technology and other growth stocks. While it has been a great time for investors recently and a lot of people are making great money, there are definitely some names in need of a breather if this rally is going to continue over the long term. With that said not all parts of the market are cranking at full speed.  I would be careful of using the market indices as a barometer for overall market performance.  Make sure you understand the weightings of the various components. I will touch more upon this later in this report.

On the fixed-income side, we saw rates bounce back slightly but still stayed in a similar range to where they have traded since April.  The 10-year treasury spent most of the month trading between 0.6% and 0.75%. Outside of a small spike up in June and a quick drop to start August this has been a pretty consistent range since April.  The Fed again reiterated that the plan to keep rates low for the foreseeable future. Until we see employment return to pre-COVID levels and inflation tick up I expect to continue to see this range-bound trading.  If they are to start raising rates at any point in the future, I expect them first to try to steepen the yield curve as part of this process.

With the continued rally in all the major indices, there is a lot of talk about the market running too far too fast and that the underlying valuations are getting too stretched.  Looking at the market as a whole, I agree the overall valuation of the markets is a bit stretched and there are a number of momentum names that could use a healthy correction.  However, if you dig a bit deeper you can see that valuations are not stretched throughout the entire market.  I would argue that the run that some companies have been on is justified. However, there are a lot of speculative momentum names that have no business being as high as they are. With that said, there are still a lot of undervalued companies in the market that have not participated in this summer’s rally.

This rally has been driven by a few specific sectors. Looking at the chart, you can see that not all sectors have participated in the rally this year. It is actually the complete opposite.  The entire performance of the S&P can pretty much be attributed to 3 sectors.  It just so happens that these three sectors also contain the top contributors to the index.  The S&P 500 is a market-cap-weighted index which means the larger the company the more it contributes to S&P performance.  That means that at current valuations the 5 biggest companies, Apple, Microsoft, Amazon, Facebook and Alphabet account for more than 25% of the S&P 500s weighting.  These 5 companies have all rallied this year leading to a great year for the normal S&P 500.  On the other hand, if you were to give every S&P 500 company an equal weight, the index would actually be down more than 3%.  The market doesn’t look quite as frothy with that kind of performance.

Sector ETF YTD
Technology XLK 30.68%
Healthcare XLV 4.52%
Consumer Staples XLP 4.30%
Utilities XLU -7.60%
Consumer Discr. XLY 18.71%
Communication Svcs XLC 17.34%
Basic Materials XLB 4.85%
Financial Services XLF -18.45%
Industrials XLI -4.68%
Energy XLE -41.74%
Real Estate XLRE -5.92%

Now, what does this continued rally, especially in tech, mean for the markets moving forward, and is it time to take some profits.  I think it is very important to revisit something we discussed a few months ago.  There are some companies that are real long-term winners during and coming out of this crisis.  These types of companies have all rallied and I would argue that even with the rally these companies have seen they still have room to run.  The tech names I just mentioned mostly fall into this category as we saw their financial results not miss a step, and even strengthen over the past 6 months. The rallies they have seen can be justified by their underlying fundamentals. I would continue to selectively add to these types of names on any significant weakness.

There are also those names that have run too far too fast and unless their fundamentals catch up very soon, they will not be able to support their lofty valuations.  These momentum names have in some cases doubled, tripled, or even quadrupled so far this year.  The bet in these names is that their increases in revenue due to COVID will continue well beyond the pandemic.  I would remain very cautious with these types of companies in the current environment. Yes, there will be some of these companies that will be able to capitalize on their increased market share or changes in consumer behavior, but their long-term success still needs to be proven. Can this increased revenue at some point translate to increased earnings? If you are someone that has made great money on these types of companies, I would strongly advise some prudent profit-taking.  If there is any continued correction or consolidation these names could drop like rocks.

This now leaves us with those names that have not yet recovered from the crisis. This actually represents a majority of the companies in the market. If you are a long-term investor and are looking for long term value, this is going to be your best area to shop. Many of these companies are down for good reason.  Many of these companies saw their revenues and earnings slashed during the pandemic and it may be years till their fundamentals fully recover. Some may never recover. However, on a relative basis, these types of companies could represent a great long-term value. Some of them will recover. Some of them will reinvent themselves and come out stronger. These names won’t be as sexy of an investment as going out and buying Tesla but that does not mean there is not underlying value in these sectors. With the run that large growth has been on, most investors are underweight the other sectors in the economy.  Now, I am not saying you should go out and sell all your large growth names and start buying energy and financials hand over fist, but now is the time to identify those companies in those sectors that will emerge from this crisis the strongest.  They could be slow to recover but they are currently undervalued as compared to their historical valuations.

With the run the markets have been on, it has been easy to ignore the continued underlying uncertainties in the economy. The most notable are the upcoming election, the uncertainty around the pandemic and how soon we will have a vaccine or other medical solution, and the ever-present tension with China. I have discussed these at length in previous reports but with the market running so far in such a short time, any negative news on these fronts could trigger some major profit-taking as traders move to the sidelines.  Regardless of any new news, I do expect some profit-taking as we approach the election. I actually think a small pullback, especially in some of the high-flying names would be very healthy for the long-term sustainability of the rally.  If the market can take a bit of a breather and consolidate for a little while we could see continued appreciation in the names that deserve it.

Strategy Commentary

I have continued to maintain my equity allocation over the past few months.  Throughout the rally, I resisted the temptation to return to a full equity allocation but have still managed to outperform the indices. This has been mostly due to my focus on tech and a skew toward growth. While I do expect some profit-taking in these areas and some potential weakness due to basic rebalancing, I will maintain these positions for the time being.

I continue to maintain my overweight to technology.  I do expect some profit-taking in some of these high-flying names but I think any pullback will be short-lived and actually healthy for the long term strength of the sector. If anything, I will be using any pullback in the sector to update the quality of the names I own as I think they will continue to outperform. As I discussed, some of the other sectors that have underperformed are starting to present an interesting value proposition. If I start to increase any equity allocation, I expect to start to add to these sectors.

As I discussed last month, I have been adding back to Europe in an effort to return to a more neutral stance there.  I continue to watch any developments with China very closely.  I think there is some great value there as they seem to have recovered the best, so far, from the pandemic.  If it weren’t for the ever-present saber-rattling from the President I would already have added more in this area but I am cautious as we head into the election because I expect the China rhetoric to only intensify because it appeals to his base.

I continue to think things will be very range-bound on the fixed-income side as we approach the election.  I continue to maintain increased cash allocations as a replacement for some of my fixed income exposure and while I definitely missed out on some opportunities as rates dropped a few months back I am comfortable with that tradeoff if it means I have more cash on the sidelines.