Stock prices rebounded sharply last quarter as investors began to anticipate an economic recovery. Whether the recovery actually comes to pass as soon as the market hopes is another thing entirely, but it is important to remember that the stock market is a discounting mechanism. In other words, it represents the collective expectation of participants. A great deal of money moved out of the market back in March as market participants expected, and therefore priced in, a high degree of pandemic related economic uncertainty. Markets really, really, hate uncertainty. As investors regained clarity, and re-adjusted their expectations, they began to re-invest cash in May. Those inflows have provided a cushion for the market on most down days and extra fuel on good days.
Both foreign stocks and domestic bonds rose during the quarter as well. Domestic bonds benefitted from direct Federal Reserve buying of corporate and government debt, while international stocks were aided by central bank activity in China, Japan, the European Union, and in the United Kingdom. Under normal circumstances, higher quality bonds might well have declined in price as the economy began to recover. Because of the Fed, the strong performance of stocks was continually supported by record low bond yields. As long as this environment persists, financial assets have the wind at their back.
The S&P 500 rose 20.5%[i] last quarter, trimming its loss on the year to -3.1%. While it may seem obvious that technology was the top performing sector during the second quarter, tech was actually third behind energy and consumer discretionary (the latter sector now encompasses Amazon and Home Depot). Energy stocks lost so much in the first quarter that even with a 32% bounce last quarter they are still down almost -35% year to date. Technology only lost -12% in the first quarter, so its 30.5% surge last quarter pushed it to a gain of nearly 15% for the year through June 30th. Utilities (up 2.7% for the quarter) and consumer staples (8.5% for the quarter) were the only two sectors that didn’t gain 10% or more. Smaller stocks enjoyed a larger bounce than large caps last quarter with the Russell 2000 gaining 25.4%. To keep this in perspective, that gain only reduced the 2020 loss to -13% from roughly -30% in the first quarter.
International markets climbed back 14.9%[ii] last quarter but are still down -11.3% year to date. There was a lot of variance between regions. China is up 3.5% in 2020 having risen 15.3% last quarter. That is by far the best foreign market performance this year. European stocks gained almost the same amount last quarter (15.4%), but that still left it down -13.2% due to their much deeper first quarter decline. Latin America soared 19.1% last quarter but that barely registered against the -45.6% first quarter debacle. Japan led the way during the quarter (19.8%) but is still off -6.2% over the six-month period.
The Barclay’s Aggregate Bond Index rose 2.9%[iii] last quarter, but that tells you very little about the average bond because the index is longer in duration (more sensitive to interest rate movements) and higher in quality that most actual bonds outstanding. Most intermediate and long-term bond funds performed much better than that, as liquidity returned to the sector. Barclay’s 1-5 year corporate bond index swung from a -2.2% first quarter loss to a 3.3% year-to-date gain on the strength of a 5.6% second quarter rally. Low quality “junk” bonds rose 9.5% during the quarter, which brought them back to -3.1% on the year. On the other hand, safe short-term Treasuries only gained 0.3% last quarter, but are ahead 3.0% for the full six months.
We began the second quarter with much higher than normal cash levels because of our concern about the economy, and while we are still somewhat overweight cash, we have been active in terms of finding sectors where we believe there is opportunity. We have added positions in convertible bond funds for our conservative investors and in health care for our more aggressive ones. For some we have ventured into sub-sectors like genomics and data centers. We are also interested in the clean energy sector, but it is currently dominated by Tesla, which is comically expensive at 787 earnings.[iv] A price like that presents too much business execution risk. We shifted some of our international stock exposure from developed markets to emerging markets during the quarter as the latter have faster growth rates and, with the exception of Brazil, seem to be handling the Covid crisis fairly well. Looking forward, we are thinking about increasing exposure to Europe as their policy responses to the crisis seem to be working better than ours, and their political situation is, for the first time in longer than I can remember, more stable than ours.
It is really difficult to forecast future market movements under any circumstances, but today it seems especially foolhardy. If the virus has a stronger than expected second wave in the fall, for example, stocks would be vulnerable because that scenario is not reflected in current prices. If there is uncertainty following the U.S. election, as there was in 2000, that would almost certainly have a negative impact (as it did then). If the current “it’s only a matter of time until we have a vaccine and things can go back to normal” narrative is replaced by something more pessimistic, the market will trade lower. The upside for the S&P 500, which as of July 27th is at 3228, relies on continued positive developments on the virus front, more normalization of the economy, and no constitutional crisis in November. If the S&P 500 was trading at 2800, simply the absence of bad news might well be enough to push stocks higher, but that is not where we are. In fact, the NASDAQ might be in bubble territory. As such, we are looking closely at our international exposure.
American stocks trade at a substantial premium because of our much greater weighting in non-cyclical growth industries (information technology and biotechnology) and our long record of political and economic stability. The former I believe will not change anytime soon, though there are some very impressive foreign technology companies like Alibaba (China), ASML (the Netherlands), MercadoLibre (Argentina), and Shopify (Canada). The latter is overstated, perhaps vastly. Financial professionals are not talking about Brexit or the Italian elections these days; the biggest political wildcard is America.
Commentary – Risk Budgeting
The last six months are about the best illustration I can imagine against trying to time the market. Even if you were so prescient as to have gone to cash at the end of February the mental anguish associated with buying back into the market would have been substantial. What would have been your buy signal? The number of new coronavirus cases? New unemployment claims? Stock market moving averages? None of those indicators have proved to be useful trading tools thus making re-entering the market incredibly difficult.
At Trademark Financial Management, we maintain a gradualist approach to managing market exposure because market timing is so difficult. We don’t believe that we can consistently add value moving all-in and all-out of the market. We marginally trim positions when we feel conditions are deteriorating and we add to positions when we feel they are improving. Sometimes we add value this way and sometimes we don’t. Our goal in the effort is to try to reduce losses, but invariably there will be some reduction in the upside that follows, because we won’t get back in at the very bottom.
That said, we believe we can add value by re-deploying the marginal amount of cash raised into areas of new market strength. After a sell-off, the characteristics of the new advance are often different than the previous advance. Recently, we have observed that the coronavirus has significantly accelerated the adoption of specific technologies. Americans are now using services like Zoom and Grubhub because they are convenient, but it is fair to say that most of us weren’t clamoring for the chance to meet remotely or have our groceries delivered before the crisis hit. Furthermore, our response to the virus is accelerating other trends like the demise of the retail store and the increased use of electronic payment.
We look for funds that are capitalizing on those trends and add them into portfolios according to “risk budgets”. Typically, a client with a greater risk tolerance will have a higher risk budget and we’re more likely to add a thematic investment. Risk budgeting also involves tradeoffs between competing investment characteristics. For example, expensive assets may take up a greater share of the risk budget.
The technology sector is up about 17% for the year and 52% since the March 23rd low. This means it has considerable risk should investors abruptly sour on it. Maintaining an overweight to technology, therefore, requires us to under-weight areas that are cheap but lagging. If momentum begins to improve in a cheap sector, such as developed market stocks, we would have to draw from technology in order to increase our weighting there, or else we would exceed our risk budget.
I think the biggest takeaway from the market this year is that nobody really knows where prices are headed. We spoke with many people about the stock market in March and to a person they thought stocks were headed much lower. Some were right for a short period of time but, of course, none were ultimately correct. Part of our job is to help investors avoid making emotional investment decisions. Everybody has heard that the key to investing is to “buy low and sell high”, but they just can’t do it by themselves. A good advisor helps their clients by tempering their emotions and keeping them focused on the long-term investment plan.
This has been a difficult year for many investors because stocks have not behaved as we would have expected given the severe shock to the economy. This leaves us grasping at what is a fair level for the market. I have an idea where that is, but I don’t necessarily expect the stock market to find that level and stay there. The Federal Reserve has added an unprecedented amount of liquidity to the financial system, which means that most of the time, stocks are going to trade above fair value. It is important, therefore, to understand the added risk that comes along with an intentionally inflated market. Using a gradualist trading approach helps us avoid getting swept up in the euphoria that accompanies a strong market, yet it keeps us from dialing back too much when things look dire. Risk budgeting is a discipline in which we recognize that if we are to take additional risk in an area that appears attractive, it has to be offset by having lower exposure someplace else. Over the three decades that we have been investing for our clients, they have really helped us keep our mistakes small. In investing, that is everything.
As always, thank for your continued trust in our management,
Mark Carlton, CFA®
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[i] U.S. stock average figures are rounded to the nearest 0.1%. They are taken from Standard & Poors through Morningstar Workstation, or in the case of sectors, directly from S&P’s quarterly summary.
[ii] International stocks performance is taken from Morgan Stanley Capital International (MSCI) again via Morningstar Workstation.
[iii] Bond performance is taken from Barclay’s Capital via Morningstar Workstation.
[iv] Source: YCharts.com as of 7/28/20