For today’s investor, there’s still a lot of uncertainty as the world tries to control the spread of the virus and manage economic growth. Questions about the pace of vaccine development, government stimulus, and economic recovery have swirled since the start of the year, and we expect them to persist well into 2021.
Amid continuing uncertainty, we wanted to take a moment to review what we have learned since the market bottom on March 20th from the perspective of the US stock market. We believe it can provide clues to longer term trends and outcomes, independent of human guesswork.
What we are finding is what we would expect: that the winners in recovery look very different than the leaders of the low-growth, quarantined world. In our equity allocations—that portion of client portfolios designed to maximize returns long-term—we have positioned client portfolios for the sustained recovery. That is where we think the better opportunity lies.
Of course, the recovery will evolve unpredictably with fits and starts, but the difficulty of timing how the recovery evolves means we have to build those equity positions today, dynamically, for the future. (Note: the equity positions in client portfolios play offense; we play defense through different allocations to fixed income and diversification.)
THE THREE PHASES
Since the market bottom on March 20, we see three phases to market activity so far (Exhibit 1).
Exhibit 1: Performance of the S&P 500 (Capitalization Weighted), Year-to-Date
- The Recovery (March 22 to June 8), where markets rebounded off their lows on massive stimulus and potential economic re-opening. Investors tried to look beyond the damage, hoping for a better-than-feared recovery.
- The Stall (June 8 to September 2), where investors returned to a small set of typical safe-havens on news about a possible second wave, stalls to further stimulus, and potential fall-off in economic recovery. Those select few stocks drove the market upwards, while most other stocks lagged.
- What we might call “the Rotation” (since September 2nd), where investors began to look beyond the clear beneficiaries of the lockdown and slower economic growth, anticipating what recovery might lead to.
The exhibit below shows the returns of the major indexes across these three phases.
Exhibit 2: Returns by Index across the Three Phases
- For context, recall that, as the pandemic hit in December-January, investors flocked—at almost any price—to the familiar “Biggest Tech, US-centric” strategy, which had worked during the past two years of limited growth and carried additional appeal during quarantine.
- During the Recovery phase, investors moved beyond the “safe, obvious winners” to stocks and sectors that would benefit from re-opening. This favored higher quality cyclical stocks at a reasonable price, more diversified portfolios, and smaller cap stocks. This positioning confirmed our strategy, which we had been building for much of the past 18 months, including the month of March.
- With the Stall phase, investors sought refuge in the “safe, obvious winners” of the recent past. But in our view, while that place may have emotional appeal, it is yesterday’s story.
- In the most recent phase since September 2, the market both sold off and recovered a bit, but there is clearly a different dynamic so far. Biggest tech has lagged, and more diversified portfolios have done better. As you might expect, our strategy has done well in relative terms—favoring small cap exposure, and more diversified portfolios.
Interestingly, Valuation has not been a sustained driver yet in either the Recovery phase or the “Rotation”:
- Recall that Valuation began working favorably during fall of 2019 but faded in December, reaching extreme dislocation by February as the pandemic spread globally.
- Much of the rebound in Value since August (end of the Stall and beginning of the Rotation) are cyclicals with weakest fundamentals—hotels, restaurants, casinos, resorts, etc. They are considered “cheap” in term of opportunity, but not in terms of earnings or cash flow, which have been decimated.
- This is why the Russell 1000 Value has done well (cyclicals exposure)…
- … even as traditional Value factors like P/E, P/Book, P/FCF, etc. are not working.
- The fact that valuation is not fully working yet highlights the flexibility of our approach. We are not anchored to Value, although it is a significant component of our strategy.
- We expect the tug-of-war between Growth and Value to continue until a vaccine is found.
- A full recovery will likely truly go into effect for investors when valuation matters again on a sustained basis. We believe we are appropriately positioned for that currently.
In other words, we need to be forward-looking and early, because it is impossible to know when the turn occurs. But in our view, it is clear where the opportunity resides. The market activity since March shows us that.