Six months into 2020, we’re seeing record highs in daily new coronavirus cases and record highs in the NASDAQ. The effects of widespread efforts to contain the coronavirus are still reverberating throughout the economy. In late February, the US slipped into an almost instant recession as the country began to close down. Mandatory stay-at-home orders and business closures erased tens of millions of jobs in a matter of weeks. Not surprisingly, the stock market reacted negatively.
From its all-time high on February 19 through March 23, the S&P 500 fell 34%. Then, with the news of the one-two punch of record-setting fiscal and monetary stimulus from Congress and the Fed respectively, the market turned and rallied just as dramatically. From the market bottom on March 23 through the end of June, the S&P 500 rose 39%, ending the second quarter just 8.5% shy of its all-time high. For the six months ending June 30, the S&P 500 was down 3.1%. As you can see in the table below, small- and mid-cap stocks rose more than large caps during the recovery but they had more ground to make up after a steeper decline during February and March. Their returns lagged large caps over the six months. Foreign stocks continued to trail; while they declined in lockstep with US large caps in February and March, they did not enjoy as significant of a recovery and finished the first half of the year with a YTD return of -11.2%, significantly below US large caps.
Bonds had a good quarter; taxable bonds and municipal bonds were both up over 2% during the period. This was a welcome reprieve after a difficult bout of extreme volatility in the first quarter. The bond market stabilized quickly after the Fed made it clear that it would provide unprecedented liquidity and support for bond prices.
|Market Index Returns as of June 30, 2020|
|Index||Peak to Trough
Feb 19-Mar 23, 2020
|Trough to Quarter-End Mar 23-Jun 30, 2020||YTD||1 Year||3 Years||5 Years||10 Years|
|S&P 500 (US Large Cap)||-33.8%||39.3%||-3.1%||7.5%||10.7%||10.7%||14.0%|
|Russell Midcap (US Mid Cap)||-40.3%||46.6%||-9.1%||-2.2%||5.8%||6.8%||12.4%|
|Russell 2000 (US Small Cap)||-40.6%||44.4%||-13.0%||-6.6%||2.0%||4.3%||10.5%|
|MSCI ACWI X-US IMI Net (Foreign Equity)||-33.6%||34.7%||-11.2%||-4.7%||1.0%||2.2%||5.1%|
|MSCI EM (Foreign Emerging)||-31.2%||32.3%||-9.8%||-3.4%||1.9%||2.9%||3.3%|
|Barclays Aggregate Bond||-0.9%||5.1%||6.1%||8.7%||5.3%||4.3%||3.8%|
|Barclays Muni Bond||-9.4%||10.5%||2.1%||4.5%||4.2%||3.9%||4.2%|
|Past performance is not an indication of future performance.|
With a spreading disease and widespread protests, it may be hard to imagine why stocks aren’t down more than they are but the economy and stock prices are two different things. Over the long term, they rise and fall together but in the short term, they can diverge widely. And for investors, the question of why prices are where they are is always less important than where are they going next. We’ve identified a few reasons why the market could fall again or continue to rise.
Reason #1: Long, hard road to recovery
We are far from being out of the woods. COVID-19 cases are rising now and some experts are saying next winter is going to be worse than what we’ve already seen. Even if we woke up tomorrow and had a vaccine, an effective treatment, or herd immunity, it would still take time to recover the economic activity and employment that we have lost over the first half of 2020.
The Federal Reserve Bank of Atlanta’s GDPNow estimate for the second quarter is for an economic contraction of -35.2% (seasonally adjusted annual rate) following a -5% fall in the first quarter. While June’s unemployment rate of 11.1% is down from April’s high of 14.7%, it is still above the 10% peak unemployment reached during the financial crisis of 2008.
There may be willingness in Congress to extend the additional unemployment benefits provided by the CARES Act which are set to expire at the end of July but no final bills have been passed. If these benefits were to expire, millions of unemployed workers may struggle to meet their financial obligations, the effects of which would reverberate throughout the economy.
Reason #2: Stocks look pricey
We felt that stocks were a bit overvalued coming into 2020. Now prices for large-cap stocks are nearly back to pre-coronavirus levels and earnings will definitely be lower this year. For the full year 2020, FactSet is projecting S&P 500 earnings to fall 21.6% compared to 2019, and revenues to fall 3.9%. If stock valuations represent the sum of future expected earnings, one could argue that prices should be lower.
Reason #3: November’s election results
We had expected to spend most of 2020 talking about November’s elections but COVID-19 and the nationwide protests about police brutality and racial inequality have stolen the spotlight. But November is coming and media coverage will shift to putting virus news, racial inequality stories and any other reporting in the context of the impact on the election. If Democrats were to take control of the White House, the House of Representatives, and the Senate, we could see a roll-back of policies made by the current administration, including those that are generally business- and investor-friendly, such as a reduction in regulations and lower tax rates.
Reason #1: Willingness to act
Federal Reserve Chairman Jerome Powell has said the Fed will do whatever it takes to support the economy. In addition to bond purchases, the Fed created several lending facilities to support different areas of the economy. Since the end of February, the Fed’s balance sheet of bonds and loans has grown by over $3 trillion. For context, the Fed’s balance sheet rose by $3.6 trillion to reach a peak of $4.5 trillion over the course of six-plus years in response to the 2008 financial crisis. Based on previous actions and statements by Fed governors, the Fed stands ready to continue to respond to any further bad economic data.
Congress also responded with record stimulus in March with the $2 trillion CARES Act, bringing combined approved spending to $2.4 trillion. The US budget deficit, projected to reach $3.5 trillion this year, has already grown by $1.9 trillion through May, compared to $739 billion over the first five months of 2019. This enormous bill will need to be paid eventually but for now, the Treasury is meeting its interest payments and long-term fiscal problems have taken a back seat.
The $3 trillion HEROES Act has passed the House of Representatives but may get stalled in the Senate. It would include direct aid to individuals, state and local governments, and employers, as well as fund virus testing, expand the moratorium on evictions, and other provisions.
The Fed and Congress likely aren’t finished in their responses to the pandemic and the resulting economic situation. Their stimulus should spur the economy throughout the recovery and beyond.
Reason #2: More effective stimulus
Compared to stimulus packages passed during the 2008 financial crisis, the recent CARES Act appears to have been more successful in terms of keeping the economy afloat. During the financial crisis, the Troubled Asset Relief Program (TARP) lent hundreds of billions of dollars to struggling banks. The banks in turn were expected to lend the money to consumers. The only problem was that the banks were slow to do so. This time around, most of the stimulus provided by the CARES Act went directly to many of the households and businesses most in need. This allowed the money provided to enter the economy more quickly, lessening the depth of the economic decline.
Reason #3: Potential of cash on sidelines
There’s another big difference between the financial crisis of 2008 and today. Coming out of the recession in 2009, the housing crisis left many homeowners saddled with mortgage balances that exceeded the value of their homes. Consumer balance sheets were in crisis. It took years for the housing market to right itself and for consumers to clean up their finances.
Today, we don’t have a similar issue of bad assets to sort out. Though more people are out of work today, the aggressive actions of Congress and the Fed have thus far provided enough support to keep consumers afloat and debt delinquencies have yet to rise dramatically. In fact, consumers are saving at above-average levels. As a result of the shut-down of the economy, consumers have been unable to go out and spend as they would normally do. Bank deposits have quickly been rising. Through May, deposits at national banks rose by $2.6 trillion compared to a year earlier, a rise of over 20%. That’s a lot of money sitting on the sidelines—money that could be invested, spent on travel, new cars or other consumption. If treatments or a vaccine prove to be effective for COVID-19, Americans collectively could go on an unprecedented spending spree. And the Fed is unlikely to spoil the party by raising interest rates any time soon given the high level of unemployment, thus allowing the spending bonanza to last longer.
Deposits, All Commercial Banks
The worst may not be past for COVID-19 but the worst of its economic effects may be. For starters, there probably isn’t enough political will to shut down the entire economy again (though sentiment could change). Additionally, we know more about the virus now than we did four months ago. We’ve learned how the virus spreads and the importance of protecting vulnerable populations. We’ve learned about the effectiveness of safe behavior including wearing masks, washing our hands and maintaining social distance—although clearly not all Americans are putting these behaviors into practice. We think we’ll see more limited and targeted shut-downs in hot spots and certainly some parts of the economy will continue to operate at levels that are well below normal capacity. For sure, there is a lot to worry about. The virus is very much with us and will impact the economy and markets for a long time yet. And still, people are getting back to work, companies are figuring out how to survive and prosper and the economy is expanding again.
Here at Bragg Financial, we have been busy trying not to take any unnecessary risks in this time of worry and volatility. In March and April, we were harvesting losses and adding to stocks when rebalancing your accounts. Now that the market has run back up, we are taking profits off the table and reducing stock exposure to stay within your target allocation. Whatever the months ahead have in store, we think this discipline is the prudent approach. Stay safe.