Note: We did not publish a monthly review letter for April, and have not published any blog posts for the past month or so, because we have been busy with consulting projects. We will resume writing blog posts in the weeks ahead as time permits.
Monthly Investment Review – May 2020 June 2, 2020
After making large gains in April, the stock market continued to climb higher in May. The S&P 500 advanced 4.5% during the month, and has now recovered most of the decline from the historic selloff that occurred in March (see Figure 1 below). In the meantime bond yields remained near historic lows, while oil prices rose, with the price of oil reaching $35 a barrel by the end of May.
Year-to-date for the first five months of the year, the S&P 500 shows a price decline of -5.8%, and a decline of -10.1% from its mid-February peak. However the Nasdaq has been much stronger, with a year-to-date gain of almost 6%, driven by powerful performance from big cap technology stocks.
Figure 1 The S&P 500 has made an impressive recovery from its first quarter selloff
Economic recovery
The market’s rebound from its March lows has been driven by hopes that the economy will make a rapid recovery from the historic downturn caused by the coronavirus. Such a recovery is expected to be driven by the large scale fiscal and monetary stimulus programs that have been put in place, along with pent-up demand following the recent lockdowns that affected most of the country. The month of May was a transition period for the economy, as many states gradually lifted restrictions and allowed businesses to re-open.
Not surprisingly, almost all the recent economic data has shown a dramatic downturn. For example the ISM Services index fell to 41.8 April, down from 52.5 in March, and retail sales showed a decline of -16.4%. The monthly jobs report for April showed a loss of 20.5 million jobs, bringing the official unemployment rate to 14.7%, and the jobs report for May, to be released in early June, is expected to show that the unemployment rate has surged to the 20% range. Initial unemployment claims have skyrocketed to 40.7 million over the past ten weeks, an average of over 4 million per week. Yet stocks climbed higher in May as investors were encouraged by various signs that the economy was re-opening in all 50 states, along with improving data in areas such as hotel occupancy rates and air travel.
Federal Reserve policy
The recent actions of the Federal Reserve have been a key factor in stabilizing financial markets and supporting the economy. The Fed has slashed short-term interest rates, made trillions of dollars available for loans, and conducted large-scale purchases of bonds and other assets. In mid-May Fed Chairman Jerome Powell said that a prolonged recession is possible, but also stated that the Fed will use its tools to the fullest extent until an economic recovery is well under way. The Fed is likely to hold interest rates at zero for some time and will continue to buy large quantities of Treasury bonds and other assets.
An easy monetary policy from the Fed has traditionally been bullish for the stock market, and the current situation is no exception. The Fed’s recent dramatic actions to support the financial system have convinced investors that the Fed will prevent the economy from falling into a depression, and will enable the economy to recover from its current malaise.
Vaccines under development
Another factor that contributed to the market’s recent gains was good news on the medical and scientific front. President Trump stated in mid-May that progress on a vaccine looked very promising, and announced a program for rapid development and distribution of vaccines. On May 18th the Dow Jones Industrials soared by more than 900 points, driven by positive results on Phase I trials of a vaccine from biotechnology firm Moderna (MRNA). Shortly thereafter several other companies, including Astra Zeneca (AZN), Novavax (NVAX) said Merck (MRK) reported similar progress, leading to optimism that a vaccine may become available by year-end.
Geopolitical developments
The virus pandemic, and China’s actions as the crisis began, have brought about a major deterioration in U.S. – China relations. The already tense relationship worsened in late May, when China effectively took control of Hong Kong. As the month came to an end, President Trump stated that the U.S. is not happy with the behavior of the Chinese Communist Party, in particular its recent actions regarding Hong Kong and the South China Sea. The Trump administration is making a number of policy changes, such as terminating the U.S. relationship with the World Health Organization.
Finally, another factor that affected the stock market in May was the fact that oil prices have recovered from their recent sharp plunge. In April, oil prices plummeted due to a worldwide glut of oil and a lack of storage capacity, but oil producers such as Saudi Arabia have now made cutbacks in output. This has enabled the price of oil to climb back above $30 a barrel, a welcome sign of stability in the oil market, as opposed to the chaotic conditions that had prevailed in April.
Market in an uptrend
Amid these developments, the stock market has steadily climbed higher for the past two months. At the end of May, a review of our indicators shows that market indices are generally in solid uptrends, and the S&P 500 has risen to its 200-day moving average. Aside from the fact that the market has become somewhat overbought, there are very few signs of weakness beneath the surface. Breadth indicators such as the advance / decline line are generally strong, and in fact have been showing signs of improvement. The VIX has been gradually declining and the put / call ratio is in the neutral range.
In addition, major changes in group rotation are taking place beneath the surface of the market. The market rally up from the March lows was driven by extraordinary strength in big cap growth stocks such as Apple (AAPL) and Microsoft (MSFT). In the weak economic environment from March until early May, these big cap technology stocks served as safe havens, because they have good balance sheets, their earnings remained strong despite the economic downturn, and they benefited from the “work at home” trend. Therefore, so far this year the Nasdaq has been much stronger than other indices such as the Russell 2000 index of small cap stocks.
However, small caps have started to outperform big caps in recent weeks, and cyclical or value sectors such as industrials and financials have started to outperform growth sectors such as technology and health care. Notably, on days when the market is driven by good news on a vaccine or other signs of an economic recovery, small cap stocks have been outperforming.
Risk Factors
As always, there are a number of risk factors in the environment that could disrupt the market’s uptrend in the months ahead. One of the main risks is that the economy could take longer than expected to regain strength. If the recovery takes a long time, earnings growth will be affected, and earnings estimates for 2021 may need to be further revised. This risk is compounded by the fact that the market’s valuation level has become very high. The price / earnings ratio based on forward earnings has risen to 23, significantly above its level at the market peak in February.
Other risks include the possibility of a renewed outbreak of the virus as the economy re-opens, and the possibility that a vaccine may not be available by year-end. Finally, the geopolitical situation remains worrisome. At this point the Phase I trade deal between the U.S. and China, announced earlier this year, is still officially in place. However there are growing doubts as to whether this trade deal will actually unfold as planned, and China may not buy $200 billion of U.S. goods as promised. President Trump may place new tariffs on China, or cancel the trade deal entirely.
Conclusion
After a selloff of historic proportions in the first quarter of this year, stocks have made an impressive recovery over the past two months, driven by optimism on the economy re-opening. The worst of the virus crisis is now behind us, and investors are hoping that the economy will stabilize in the third quarter and then show a strong resurgence in the fourth quarter and into 2021.
The market has already priced in a lot of good news, and to a large extent the market outlook depends on how fast the economy can re-open. Medical developments regarding progress on a vaccine and widespread availability of testing may be a major factor in this regard.
One of the keys to good investment performance this year was to do some buying when the market was extremely oversold in late March and early April. This is what we advised in our blog posts in March. In fact we advocated buying triple leveraged exchange traded funds, such as the triple long Nasdaq 100 ETF (TQQQ). This strategy was very successful, and these ETFs have produced large percentage gains over the past two months, making a major contribution to performance.
However at this point, the market’s risk / reward ratio has become more balanced than it was in late March. Due to the market’s higher valuation level and other factors, at this point we would not be using leveraged ETFs, except perhaps in the small cap area. In the recent market selloff, the Russell 2000 became extremely oversold, and we believe that small cap stocks are likely to outperform as the economy recovers.