Quarterly Letter 2Q 2020

Improving Economy

The main factor driving the stock market higher in the second quarter was the trend toward re-opening the economy, along with hopes for a strong economic recovery in the second half of 2020 and into 2021. 

The virus pandemic has caused a sharp recession of historic proportions.  The government’s employment report for April showed a loss of over 20 million jobs, mainly in industries such as restaurants, retailers and other small businesses, with the unemployment rate spiking up to 14.7%, a level not seen since the Great Depression.  In the past few months, initial unemployment claims have totaled over 45 million, representing almost 30% of the total U.S. labor force. 

But over the past month there have been many signs that the labor market has turned the corner and has started to improve.  The monthly jobs report for May was surprisingly strong.  Economists had expected a loss of 8 million jobs and an unemployment rate of 20%, but instead the data showed a gain of 2.5 million jobs and a drop in the unemployment rate to 13.3%.  The jobs report for June was just released, and again was surprisingly strong, this time showing a gain of 4.8 million jobs, with the unemployment rate falling to 11.1%.

These reports showed that small businesses are re-opening faster than expected, and that many people who were laid off have already gone back to work.  One recent survey showed that 79% of small businesses have either fully or partially re-opened.  The government’s economic rescue package has had a positive impact, as the Paycheck Protection Program (PPP) has made over $500 billion in loans to small businesses and saved millions of jobs.

In addition there have been numerous other signs of improvement in the economy over the past two months.  These included an increase in the ISM Services index, a rebound in consumer confidence, and a strong gain of 18% in retail sales in May.  The housing sector has also been a bright spot in the economy.  In mid-June the National Association of Homebuilders sentiment index rose sharply, new home sales rose by 17% in May, and data released in late June showed that pending home sales grew at a 44% annual rate.  Mortgage applications recently showed a year-over-year gain of 21%, as mortgage rates are at historic lows, which is also leading to strong refinancing activity. 

Government Stimulus Programs

One of the main factors that has led to investor confidence about an economic recovery is the massive amount of stimulus provided by various government programs to address the pandemic.  Having already spent several trillion dollars on small business loans and various other fiscal programs, Congress and the White House are now negotiating a Phase 4 stimulus program which could provide another $1 trillion or more to further bolster the economy.  The structure of this stimulus bill could have a major impact on job creation in the months ahead, depending on whether the bill includes measures such as a payroll tax holiday, liability protection for small businesses, and favorable tax treatment for restaurants and entertainment. 

The Federal Reserve has also taken aggressive action and has provided a large amount of support for the financial system, slashing short-term interest rates to zero, providing trillions of dollars for various types of lending, and conducting large-scale purchases of bonds and other assets.  Fed Chairman Jerome Powell has indicated that monetary policy will remain very dovish, as the Fed is planning to hold interest rates at zero for two more years, and will continue to buy Treasuries and other bonds as needed to support the economy.

Resurgence of Virus Cases

On June 11^th the Dow Jones Industrials plunged by over 1800 points, on news that the number of virus cases was rising rapidly, especially in states that have gone a long way toward re-opening their economies, such as Texas, Florida and Arizona.  The resurgence in virus cases over the past few weeks has reached worrisome levels, and is raising questions about how fast the economy can re-open. 

The increase in cases can be explained by factors such as increased testing and the spread of the virus among young people in bars and other social settings.  In response to these alarming trends, many states have had to reverse their policies on re-opening.  The Centers for Disease Control said that states may need to re-implement social distancing rules.  However the good news is that despite the increased number of cases, many are among younger people who are not seriously ill and may be asymptomatic.  The number of hospitalizations is not leading to a corresponding increase in ICU admissions or fatalities, so the mortality rate (number of deaths per number of new cases) remains low. 

Amid these developments there has been hope that a vaccine can be developed by the end of the year.  Numerous major pharmaceutical companies are working on therapies and vaccines, and Dr. Fauci recently stated in Congressional testimony that he was cautiously optimistic that a vaccine would be available by early 2021.  

Market Indicators Still Bullish

A review of key stock market indicators shows that the market conditions remain generally healthy, except for the fact that the market has become fairly overbought.  Breadth indicators generally look good, money flow indicators remain positive, sentiment indicators are neutral, and leading stocks continue to make news highs.  Thus the market is not showing any major worrisome signs of a peak. 

However, on a valuation basis, stocks are now expensive by historic standards.  S&P 500 earnings per share were $163 in 2019, but are expected to drop to roughly $125 in 2020.  The S&P 500 ended the second quarter at a price of 3100, meaning the price / earnings ratio has risen to almost 25 times forward earnings, a very high level.  However, interest rates have fallen to such low levels that bonds do not provide attractive rates of return.  Thus market analysts have coined the term “TINA” for “There Is No Alternative” (to stocks), meaning that stocks are the only way to make a decent rate of return in today’s environment of extremely low bond yields.  This explains why the market’s P/E ratio has become high by  historic standards.  In fact if interest rates stay near current levels, the stock market’s valuation level may continue to rise.

There are still trillions of dollars of cash on the sidelines which could come into stocks and drive the market higher.  Many investors have missed the sharp rally that unfolded in the second quarter, and therefore they are eager to get into the market on any pullback.  Data on mutual fund cash flows recently showed that $20.4 billion flowed into equity mutual funds in one week in mid-June, the largest one-week inflow since 2007.  These strong cash flows into the market would explain the persistent gains in the largest stocks, such as Apple, Amazon, Google and Microsoft, which are widely owned by mutual funds.

For the past several years, big cap growth stocks have been outperforming other parts of the market such as small cap stocks, especially small cap value.  However if virus cases subside and the economy starts to accelerate, we expect small caps and value sectors such as energy and financials to show renewed strength.

Buying Stocks Near the Market Lows

A key element in creating good investment performance this year was to aggressively buy stocks when the market was near its lows in late March and early April.  This is precisely what we recommended in our blog posts in mid-March. 

In our comments for the week ending March 13, 2020 we wrote “Large percentage gains can be made by buying at very oversold levels, especially using double or triple leveraged ETFs … This is not just for short-term trading purposes.  We may want to hold these stocks or ETFs for years, and buying them at very oversold levels can make a major contribution to performance.  Thus it would make sense to place buy limit orders on a variety of stocks and ETFs, such as TQQQ in the $35 – $45 range.“  

The triple leveraged Nasdaq 100 ETF (TQQQ) then fell to a low of roughly $32 in late March, meaning that all of these buy orders were executed, resulting in a TQQQ position with an average cost of $40.  The market then turned up in April, and when the price of TQQQ reached $60 we recommended taking profits to lock in a 50% gain.  However, depending on client risk tolerance, we might hold part of the position as a long-term holding.  As of June 30, 2020, the price of TQQQ had risen to $97.65, resulting in a gain of 144% in three months. 

Note that in order to execute this highly profitable investment strategy, we did not need to forecast exactly how fast the economy would recover, or predict exactly how much the market would rise in the second quarter.  We simply needed to recognize the fact that in late March, the market was becoming extremely oversold and much of the bad news was priced in.  Historically such extremely oversold conditions have been followed by strong rebounds. 

This is an example of the idea, outlined in various articles on our blog, that successful market strategy does not require making perfect forecasts of the economy.  Instead, it involves assessing the mosaic of economic and market activity as events unfold, and spotting investment opportunities when they arise.

Risk Factors

Despite widespread expectations that the economy will make a strong comeback over the next year or so, there are a number of major risk factors that could derail the market’s uptrend in the months ahead.  One of these is the possibility that the resurgence in virus cases continues to grow and becomes more serious, causing damage to the economic recovery.  Earnings for the second half of this year might be below expectations, although earnings visibility is already very low.  In fact earnings reports for the second quarter will be released over the next month or so, and the guidance provided by corporations will be a key factor influencing the market throughout July.

Another risk involves geopolitical factors such as growing tensions between the U.S. and China.  China has recently taken control of Hong Kong and the U.S. has therefore cancelled its long standing “special status” relationship with Hong Kong.  China has also grown increasingly belligerent toward many of its neighbors, including India, raising the possibility of some type of military confrontation with the U.S.  The pandemic has underscored the importance of U.S. economic independence from China and the need for at least some de-coupling of the two economies.  The China trade deal is still officially in effect, but there is still a chance that the deal could fall apart or that new tariffs could be imposed.

Another major risk for the market involves the domestic political situation, as the November elections are rapidly approaching.  In the months ahead the market will increasingly focus on the elections.  A change from the current administration would likely mean major changes in policies on taxes, regulation and energy, which could hurt the economy and therefore could be bearish for the market.

Conclusion

Because of the coronavirus crisis, the stock market has made a dramatic V-shaped move in the first half of this year, amid equally dramatic developments in the economy.  The recent economic downturn has been unprecedented and therefore the speed of the recovery is very difficult to predict with normal economic models.

After its rapid advance in the second quarter, the stock market has become quite expensive by historic standards.  Prices have risen, but earnings expectations have been revised down, so the price/earnings ratio is now in overvalued territory.  But this high valuation level alone is not enough to derail the market’s uptrend, given the fact that interest rates are at extremely low levels.

We have been bullish on the stock market for the past three months and remain generally positive on the market outlook, although the risk / reward ratio now shows a lot more risk than was present in March, when stocks were very oversold and valuation levels were much lower.

Thus while we expect further upside ahead, the extent of any market gains will depend on a number of factors that are more unpredictable than usual, such as developments with the virus, the extent of the economic recovery, geopolitical risk with China, and political developments in the U.S. as we approach the November elections.