Investment Review – Third Quarter 2020 October 2, 2020
The stock market made solid gains in the third quarter, with large advances in July and August, followed by a pullback in September. The S&P 500 rose 5.5% in July and 7.0% in August, then declined by -3.9% in September, for a gain of +8.5% for the third quarter as a whole. The Nasdaq gained 11.0% in the quarter. Year to date, the S&P 500 is up 4.1% while the Nasdaq has gained a remarkable 24.5%, despite the sharp selloff in the first quarter. However, small cap stocks have been much weaker this year, as the Russell 2000 index has posted a year-to-date decline of -9.6%.
Bond prices were roughly unchanged in the third quarter, as the yield on 10-year Treasuries ended September at 0.68%. Year to date, bonds have been very strong, as the long-term Treasury bond iShares have gained roughly 20%. The dollar declined in the third quarter, the price of gold rose, and the price of oil was roughly unchanged.
Figure 1 S&P 500 index – first 9 months of 2020
The main factors driving the stock market during the quarter were improvement in the U.S. economy, hope for more fiscal stimulus measures, and optimism that a vaccine for the Covid-19 virus could be approved and widely distributed by early next year.
Economic Recovery
One of the main factors contributing to the market’s gains in the third quarter was the improvement in the economy. The unemployment rate remains abnormally high and millions of people are still out of work, but much of the recent data supports the thesis of a “V-shaped” economy this year. The gross domestic product (GDP) plunged dramatically at an annual rate of -31.4% in the second quarter, but when data is reported for the third quarter, most economists now expect an equally dramatic gain, with a growth rate in the 25% – 35% range.
Recent employment reports have been stronger than expected, as 4.8 million jobs were created in June, 1.8 million in July, and 1.4 million in August. The most recent data shows that another 661,000 jobs were added in September, as the unemployment rate fell to 7.9%. Other labor market reports have provided evidence of a recovery in the small business sector.
The consumer confidence index rose to 101.8 in September, up sharply from August, auto sales have been strong, and inventories are low, which implies that manufacturing will be strong in the fourth quarter. The ISM manufacturing index has shown healthy readings in the 55 – 56 range for the past few months. Also the housing market has been very robust, driven by low interest rates. Recent data on housing starts and home sales have been very strong, and the National Association of Homebuilders (NAHB) optimism index has been rising sharply for the last few months. Amid this economic recovery, third quarter earnings may be stronger than expected when they are reported throughout October.
Federal Reserve policy
In mid-September the Federal Reserve held a policy meeting and announced that it plans to keep short-term interest rates at zero for several more years, through 2023, and will continue to buy large quantities of bonds (quantitative easing). This is based on the view that it will take several more years for the economy to fully recover from the recent recession.
In addition, in August the Fed announced a new strategy for monetary policy. This approach will focus on reaching the goal of full employment, even at the risk of higher inflation. For years many economists had considered the lowest possible unemployment rate to be somewhere in the range of 4.0% – 5.0%, but in the past few years unemployment fell to the 3.5% range, as the strong economy created millions of new jobs.
Thus Fed officials would like to promote a return to a thriving economy with the unemployment rate down to the 3.5% range. To do so they will target an inflation rate that averages 2.0% over time, which implies that they will sometimes allow inflation to rise above 2.0%.
In essence, the Fed is abandoning the “Phillips curve” model from economics textbooks, which stated that a strong economy leads to higher inflation. The net result is that for the foreseeable future, the Fed will try to stimulate the economy with all of its policy tools. In general, this is bullish for the stock market.
Vaccine Development
Optimism on development of a vaccine for the coronavirus was a major factor contributing to the market gains in the third quarter. Phase 3 trials are underway for a number of vaccine candidates from major pharmaceutical companies such as Novavax (NVAX), Pfizer (PFE), and AstraZeneca (AZN). When a vaccine is approved by the FDA, hundreds of millions of doses are expected to be produced over a short time period.
In early September, the Centers for Disease Control (CDC) told the states to prepare to start distributing a vaccine before November. This suggests that a vaccine might be completed as early as October. In September Dr. Anthony Fauci stated that he expects a vaccine to be widely distributed to the entire U.S. population by the second quarter of 2021.
There was also good news on potential virus treatments and therapeutics. In late August, the FDA authorized the use of convalescent plasma, which has been shown to reduce mortality rates, and in late September, President Trump announced that Abbott Labs will soon be producing 150 million rapid virus tests, which should help with the re-opening of schools, as well as the economy in general.
Status of Market Indicators
By the end of August the stock market had been rising for five months, and reached a very overbought condition, with some technology stocks displaying a “climax top” pattern that is typical of a market peak. The market then pulled back in September amid rising political uncertainty regarding the November elections.
As October begins, our review of the market’s technical condition shows that the market is generally in a neutral position, with some positives and some negatives. The long-term trend is still bullish with no signs of a long-term peak, but the short-term picture is mixed. In late September both the S&P 500 and Nasdaq fell below their 50-day moving averages, but the indices are still above other support levels such as the 200-day moving averages. After the large move up from the March lows, a deeper pullback to these support levels would not be unexpected. In late September the market turned up and formed some signals indicating the beginning of a new uptrend, but the evidence supporting a new uptrend is still rather weak at this point, and requires more confirmation.
Sentiment indicators are now in the neutral range, as optimism has come down from the excessive readings seen at the market peak in early September. Seasonal patterns are unfavorable for the next month or so, as October tends to be a weak period for the market.
As far as market valuation is concerned, the S&P 500 index ended the third quarter at a price of 3363, and the consensus earnings estimate for 2021 is approximately $166. This means the market’s price / earnings ratio, based on next year’s earnings, is 20.3. This is a fairly high level by historic standards, but not excessive.
Given the extremely low interest rates on both cash and bonds, investors have been pouring money into the stock market, because stocks are one of the only asset classes with the potential to produce a decent rate of return (this is the so-called “TINA” case for stocks, meaning “there is no alternative.”)
We remain bullish on selected industry groups such as the homebuilding stocks, which have been acting very well lately and have shown good relative strength during the market’s September pullback, a very positive sign.
In our opinion, the key to making high returns in the market this year was to buy stocks aggressively when the market was extremely oversold in late March. This is what we recommended in our blog posts in March (please see blog posts such as “Our Investment Strategy Has Far Outperformed a Buy-and-Hold Approach This Year” for more detail).
Summary and Conclusion
As we look ahead to the fourth quarter, the market outlook is mixed, as good news from the economic recovery is offset by a number of major risk factors.
On the bullish side, the Federal Reserve is maintaining a very expansionary monetary policy, and another fiscal stimulus package is possible. Rapid virus testing is becoming available, and a vaccine may be announced before year-end, which implies that the economy should continue to make a strong recovery in the months ahead.
But this rosy scenario is tempered by some major risk factors, most notably the potential for political chaos after the November election. The winner of the election may not be clear on election night, due to issues involving mail-in ballots, etc. If there is no clear winner in November, there could be a contested election, with legal battles that could drag on for weeks or months, potentially even leading to a Constitutional crisis. This already tense political picture has become even more uncertain in recent days with the Supreme Court nomination and the President’s medical condition.
Also, a recent spike in virus cases in the U.K. has led to worries about a possible second wave of virus cases in the U.S. In addition, geopolitical risks could rise after the election. For example, earlier this year tensions were rising between the U.S. and China, but recently the geopolitical picture has been fairly calm, as many foreign countries appear to be waiting to see the outcome of the U.S. elections.
But domestic political events will probably have the most influence on the market in the near term. In general, we believe that the market would react more favorably if President Trump is re-elected, simply because the economy would benefit from a continuation of policies such as low tax rates and reduced regulations. The election outcome for control of the House and the Senate is also important. In general the stock market does well in periods of gridlock, in which different parties control different branches of government, because this implies no dramatic policy changes of any kind.
Thus at this point we believe that some caution would be prudent, and we would maintain a balanced asset allocation until the election uncertainty is resolved and the political picture becomes more clear.
Jonathan Strauss, CFA
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