In the second quarter of this year, U.S. GDP dropped a staggering 31.7%, unemployment skyrocketed, and many small businesses were forced to close permanently. Moreover, the Congressional Budget Office reported this week that federal debt held by the public is projected to reach or exceed 100% of gross domestic product, putting the U.S. in the company of a handful of nations that include Japan, Italy and Greece. The global economy is in deep-recession territory….and yet, at the same time, the stock market is booming. The stock market has seen wild fluctuations this year with some of the fastest and sharpest swings ever seen in U.S. market history. Indeed, after falling 35% from its February high to its March low, the S&P 500 has now risen for 5 straight months registering its largest five-month percentage gain since 1938.
Many clients and market pundits are asking, “Is this irrational exuberance?” Well, it could be. However, there are several reasons why the market is performing so well in the face of horrible economic news. Second quarter earnings reports were dismal but were 23% better than expected. The market is forward looking and is already looking past 2020’s down earnings. Current consensus expectations are for a 26% rebound in S&P 500 earnings in 2021 with further growth expected in 2022. In addition, monetary and fiscal stimulus has been a key ingredient in the market’s remarkable rebound, and we anticipate both stimulus measures to continue. Indeed, the Fed announced a change in its policy which will enable it to keep interest rates at very low levels for a long time. Amazing scientific progress continues on developing coronavirus vaccines and therapeutics. Several companies are in the midst of Phase III trials with hope for widespread availability of vaccines within several months.
But perhaps the main reason for the dichotomy in the performance of the economy and the market is that the capitalization-weighted S&P 500 index is not representative of the U.S. economy. Some of the hardest hit industries include department stores, airlines, hotels, travel services, oil & gas equipment service, resorts and casinos. But these sectors have negligible presence in the S&P 500 index. Department stores make up 0.01% of the index, airlines account for 0.18%. Restaurants are almost 1% but half of that is McDonald’s. The same is true for the other industries listed above. On the other hand, Apple and Microsoft together make up over 12% of the index and the entire technology sector accounts for over 28%.
The market has made a clear distinction between the winners and losers in this pandemic. Year-to-date, the technology sector is up 33% while the energy sector is down 42%.While the S&P 500 index is near its all-time high, less than 35% of the stocks (and only 3 sectors) in that index are outperforming, an unusually low number indicating narrow breadth.
So, where do we go from here? We expect volatility to continue for the remainder of the year with the election taking place in the midst of the ongoing pandemic, social unrest, the start of the school year and attempts to reopen the economy. The uncertainty caused by the pandemic will remain until further progress is made on treatments and vaccines. But the market will continue to reward those companies who continue to generate an increasing flow of free cash flow – which can be used to invest in future growth opportunities and/or return to shareholders.
Dr. Ed Yardeni recently discussed the technological innovations that drove the prosperity of the 1920s and then highlighted “the awesome technologies that are just starting to proliferate in ways that should boost productivity and prosperity”: home-based work, education and entertainment, telemedicine, a next-generation speed upgrade to wireless networks, robotics, automation and 3D manufacturing and batteries. Companies involved in these new technologies along with those that have managed to produce free cash flow throughout all types of economic environments should thrive in the coming decade.
The LVM Team