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The Brave Report: Market Commentary for October 2020

Click here for .pdf version of this report: https://www.braveboatcapital.com/wp-content/uploads/2020/10/The-Brave-Report-October-2020.pdf

Let’s all stop and take a deep breath (through our masks of course).  The markets finally took a long-needed pause, registering their first loss since March.  Profit-taking from the recent runup, uncertainty around the economic recovery, fear of a resurgence of the virus and uncertainty around the election all forced traders and investors to take a little bit off the table and reassess their equity exposure.  It is not surprising to see a little softness in the equity markets as the rebound in the markets has been so swift.  If we want the markets to continue to move higher, pauses like we just saw are important to allow economic data to catch up to the movement in the markets.  Until some of these uncertainties work themselves out, I expect some choppiness to exist moving through the rest of the year.

Market Overview

The three major indices all lost ground during the month of September with the Dow Industrials and S&P 500 losing 3.4% and 3.9% respectively, while the Nasdaq dropped around 4.4%. While these losses are quite modest if we consider the runup we have seen over the last few months, all three indices were down more than 10% from their highs midway through the month.  These types of 10% corrections are actually quite common, the uncommon thing is how fast these market moves are happening.  The rally up and the subsequent correction seem to be on an accelerated timetable.  There has been a lot of speculation as to why these moves are happening so rapidly, but it seems that algorithmic trading combined with an uptick in retail investing during the pandemic is causing an exaggeration of moves in both directions. These fast moves also tend to easily overshoot in both directions which can present some good opportunities for the patient investor.

On the fixed income side, we saw very little movement of rates with the 10-year treasury spending most of the month yielding between .65 and .7%.  We did see a bit of a spike in rates in the last day of trading and in the first few days of October as the President’s Covid-19 diagnosis shook things up a bit.  The Fed again reiterated that rates would stay very low for a while and with the expectation of additional stimulus, I expect any spikes in rates to quickly be bought. Since the pandemic hit there seems to be a magnet around 65 basis points for the 10-year and I expect this to continue.

With less than a month to go before the election, it has now moved to center stage and we have seen constant debates about the economic impact of either side winning.  Although I never like to downplay the importance of an election, I tend to believe that the actual market impact of a presidential election is often over-hyped, and its short-term impact is often quite muted.  Campaign promises tend to be more rhetoric and pandering than actual policy recommendations or promises. Add to this the fact that we have gotten very few specifics around what Bidens’s actual economic policy will be and it becomes exceedingly difficult to make any judgments about what a Biden win would really be for the economy. For the most part, Biden’s support is not driven by specific policies but rather the “anyone but Trump” narrative. Hopefully, we get more specifics as to his policy intentions so we, as investors, can make proper judgments.

With that said, a presidential election combined with changes in the house or senate can have a larger impact on long-term economic outlooks.  No matter which side you support, circumstances when one party controls both houses of Congress and the Presidency can increase the probability of more extreme policies becoming a reality.  Whether those policies are beneficial or not, the markets hate uncertainty and also prefer incremental changes over extreme changes. Extreme change is difficult for companies to plan for and can have a greater shock on company fundamentals. Markets like predictable fundamentals.

The more troubling short-term variable that I see for the markets is how the results are viewed by either side, how contested the results are and if there is a smooth transition of power. With the pandemic disrupting voting procedures and the continued accusations of voter fraud being yelled by both sides it is easy to see a situation where the results are not ratified for weeks, if not longer. Outside of a complete landslide victory by one side, I expect a long drawn-out process to actually ratify the winner.

Even more disturbing is the potential that there is not a smooth or peaceful transfer of power if Trump loses. He has already stated that he may not accept the results, and this puts our country on the road to a very dangerous and embarrassing few months. While there are processes in place to avoid this scenario, we have never had to deal with something like this in modern times.

Under either or both of these scenarios, the markets will probably not react positively.  I think the expectation of contested results is already being priced in, to some extent, but the longer it is drawn out the more I could see investors ringing the register and just waiting for everything to play out before reentering.  As I continue to say, markets hate uncertainty and when left with too many uncertainties, people just move to the sidelines.

Outside of the election, the big elephant in the room continues to be the prospect of a resurgence of the Coronavirus and what the government response will be. In Europe, we have already seen a reinstitution of some of the restrictive measures that we saw in the spring as cases have spiked in some areas.  I do not expect such measures to be as successful domestically this time around as it has already become quite apparent that in certain areas of the country people are committed to continuing business as usual. From a market standpoint there are a few key variables to watch:

  • How do medical solutions continue to progress? We have already seen mortality and hospitalization rates come down drastically in most populations.  There has also been real progress on the vaccine front, and I would not be surprised to see a vaccine come to market in the next few months.  However, even with the medical advances, it does not mean the problem is solved. Will we be able to distribute the vaccine in enough concentration to make a quick difference? Additionally, coming up with a medical solution is one thing but will these medical solutions be able to alleviate the ingrained fear that still exists in much of the population.  Just because a vaccine is released and the economy fully opens again does not mean everyone will just start going out to dinner, the movies or flying again. Human behavior does not change overnight, and I think it will be a few months before some parts of the economy start to return to normal.
  • What long term economic damage has already been done?  With so many businesses closing over the past few months it is difficult to get a full grasp on how many are closed permanently and how many will reopen.  It will be months till we get an understanding of what the real long-term damage will be. It will be important to continue to monitor job growth as we come out of this to really understand what and where the damage has been done.
  • Is there continued government response to support the economy? The timing of the election has put stimulus negotiations in a precarious place.  What kind of aid or stimulus packages will be able to be negotiated this close to the election?  Based on the President’s recent tweets it seems unlikely that a full stimulus deal is reached before the election.  The Democrats have little reason to give the President a win this close to the election and Trump is currently focused on pushing a new supreme court justice through confirmation.  I’m not saying we won’t see some sort of aid get approved, but it will not be the sweeping stimulus that we need.

Strategy Commentary

During the midmonth dip, I added a little to my overall equity allocations.  I used the pullback as an opportunity to fill out some client allocations and put a little cash to work in some high-quality names.  These were small additions and not major shifts but with some of the big tech names dipping around 20%, it gave me an opportunity to put some money to work.  If we do see any weakness around the election, I expect to continue to allocate some of the excess cash some clients are currently sitting on.  While I still have not returned to a full equity allocation, I am opportunistically adding to quality names, not speculative ones.

Domestically, I continue to maintain my overweight to technology.  Even with the pullback, we saw this month I think this sector still has the best long-term prospect for growth.  I also continued to shift more to large-cap names over small-cap.  I think the growth potential is greater in small-cap names, however, if there is a resurgence of the Coronavirus, the larger companies will hold up better and I am willing to make that tradeoff.

On the international side, I stopped adding back to Europe as the prospects of another virus lockdown look more realistic.  Asia and some Chinese names, in particular, have also become a lot more interesting.  If we believe the data coming out of China, then their handling of the virus and the subsequent economic recovery has returned the country to close to normal. Add on top of this the prospects of a Biden win and some Chinese names could have some room to run. I am not going fully overweight here but will opportunistically add some large-cap Chinese names.

While there has been a recent spike in rates, I expect rates to settle back down and continue to be relatively range-bound. Cash is still king here and I would rather maintain a higher cash allocation as a replacement for some fixed income exposure at this point.

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