Economic update: The ups and downs of the equity market (webinar)
At the beginning of the year, the economy was in good shape. Earnings per share had an expected growth of 5% and the S&P 500 came within a few points of reaching a high of 3400.
Fast forward to March, COVID-19 hits and the market has a 35% sell-off in 23 days. The main reason for the drop was that the market was pricing in the economic recession and the earnings collapse that was about to happen. At the time, there were several companies at risk of going bankrupt.
However, the Federal Reserve (Fed) stepped in and provided a backstop to the market. The Fed was able to lower interest rates providing the liquidity for credit markets that was greatly needed. This helped save a lot of those companies that were at risk of going under.
What is going on with the stock market?
Since the end of April through June, we have seen a continuation of the rally from the Fed backstop as well as local economies starting to open again, which is good for consumer spending and, therefore, earnings. There was also talk of a possible vaccine, which fuels the markets. However, there is still some speculation out there, which can be worrisome.
Right now, we think the market is in a 2800 to 3200 trading range, which represents a +/- 5% range from where we are currently at. Below are the reasons we see 3200 as the top of the range:
- The market is technically overbought
- There is a significant amount of risk that could limit the upside
- Evaluation stretch
At the lower end, we see good support. There is a potential for additional stimulus if the market does sell off, low interest rates tend to encourage money to move into the equity market and trillions of dollars of cash are on the sidelines.
Our updated forecast for the S&P 500 is 3000, with a 2800-3200 range for the next few months.
What is leading the market?
There’s an old saying on Wall Street: “Don’t fight the Fed.” This simply means that when the Fed is easing policy or lowering interest rates, you want to buy stock, and when the Fed is tightening policy or interest rates, you want to sell.
This strategy historically has a good track record. We believe the Fed has been the primary driver of the 45+% rally we’ve seen off the March 23 lows.
Historically, when nearly all central banks—also known as reserve banks—are cutting rates, you want to be buying stocks. Going back to the early 2000s, you had every central bank around the world cutting interest rates and that coincided with a bottom in global stock. Looking back to 2008-09 it was the same story. Today, it’s not only that global central banks are cutting rates, they are also engaging in what we call unconventional monetary policy.
The Fed has been the primary driver for the rally that we’ve seen in the stock market and there will likely be a tailwind for markets over the next couple of years since rates will stay low through at least 2022. Other factors include the re-opening of the economies, unpreceded levels of fiscal policy and the hope for a vaccine that can rapidly return the market to normal.
What’s driving the market from a sector standpoint?
- Technology sector: This is the best performing sector so far this year. If you compare it to the energy sector, you can see that it’s up 12.3% versus. -34.8%. Our economy has shifted from being commodity and manufacturing based to a service-based economy and that has benefited the tech sector. However, if you look at the breadth of the market, there is just a small number of large cap tech stocks leading the market, such as Amazon, Microsoft and Apple. These stocks are given more weight in the S&P 500 compared to the S&P Equal Weight Index:
- YTP the S&P 500 equal weight is -14.7% vs. the S&P 500 -6.1%
- The five largest stocks make up >20% of the S&P 500 and are driving the return of the S&P 500
- Important to have a mix of active and passive investments
- COVID-19 stocks: These are the stocks that have benefited from the stay-at-home orders such as Amazon and Netflix. This would also include home improvement centered stocks and reopening stocks, such as high-quality restaurants that have clean and comfortable environments such as Starbucks and Chipotle.
- Speculation: We are investors and not speculators, but we are aware of it. We have seen a lot of traders being active in speculative companies. We view this as an indicator that the market may be too optimistic. Many of these companies crash hard and take years to recover.
Signal the market is sending
The stock market is a leading indicator for the economy and shows what happens over the next 6-9 months. The U.S. economy will get through COVID-19 and there will likely be some sort of vaccine in 2021. As a result, consumer behavior will revert back to normal and the recession will likely be short lived.
Since the market bottomed in late March, historically the recession would end in the July to August time frame. However, it’s important to note that the speed of the recovery hinges on two factors: consumer confidence and the vaccine.
Looking at the valuation, we are in a unique situation today. Stocks are going up, yet earnings are going down, so we recommend to hold your investments.
What are the risks
- A second wave of COVID-19. We have already seen some states shutting down again
- Consumers choosing to self-quarantine and adjusting their behaviors which will push out earnings recovery
- Time and scope of the stimulus package and if another package will pass in late July or early August
- How many businesses will be permanently damaged and how this virus will change consumer behaviors
- How the presidential election will impact the market
- Oil has recovered significantly however there is still a surplus of supply
- Market consolidation
- Trade with China
One upside risk is having a vaccine earlier than expected, which could lead to market upside above our current predicted range.
We recommend people remain slightly defensive due to unattractive risk/reward in the market. Invest and own quality stocks for the long-term. When looking for a quality stock, look for a firm that has earnings, an above average return on capital profile, a manageable balance sheet and a cash flow that could support a dividend or capital return to shareholders. Use market pullbacks to put cash to work and have a healthy mix of active and passive investments.
Key market takeaways:
- Expect the S&P 500 to be in a trading range of 2800-3200 for the next several months
- Market recovery is driven by the Fed backstop and anticipation of a COVID-19 vaccine
- A second wave of COVID-19 is the main risk
- The market is signaling an economic recovery
During this uncertain time, we want to assure you that UMB remains committed to providing the customer service that you have grown to know, while helping to ensure the health and safety of our associates and clients.
When you click links marked with the “‡” symbol, you will leave UMB’s website and go to websites that are not controlled by or affiliated with UMB. We have provided these links for your convenience. However, we do not endorse or guarantee any products or services you may view on other sites. Other websites may not follow the same privacy policies and security procedures that UMB does, so please review their policies and procedures carefully.