Q2 2020 Market Update

In one of the most unusual years ever, investors have experienced extreme quarterly moves up and down, and the year is only halfway done. The stock market (S&P 500 Index) had a speedy, record breaking, thirty-four percent drop into bear territory and the economy had its quickest deepest recession on record. The stock market has massively rallied from the March abyss because of government stimulus and positive news on swift development of a coronavirus (CV) vaccine. With a forward-looking market pricing in a U.S. economic recovery, stocks will continue to recover from their steep bear market losses. I expect more volatility and uncertainty to come later this summer as the presidential election becomes a focus for markets, but I do not anticipate a retest of March lows based on market action and improving fundamentals.

Historically, when S&P 500 Index retraces with broad market breadth, like we saw over the last quarter, it is a bull signal. The exception was in the Great Depression when the Fed shrank the money supply errantly and bank failure was widespread. In contrast, the U.S. economy has just witnessed the greatest increase in money supply ever, and U.S. Banks are extremely well capitalized.

The Fed has been extremely proactive and justified in steps taken, given the economic situation, with government stimulus and liquidity programs mimicking close to fifty percent of U.S. GDP. The Fed provided sufficient liquidity to assure that key financial markets, including the treasury, mortgage and repo markets, functioned in a normal way, backstopped critical credit markets, and eased monetary policy by cutting rates to zero and buying corporate bonds.

The stock market technical indicators and internal indicators are confirming that the recession ended, and that the stock market entered a new bull market. The second quarter stock market performance was one of the best signals to a bottom on earnings decline.

Earnings are likely to finish bottoming in July and then recover strongly over the next twelve months aided by unprecedented monetary and fiscal policy. It is obvious that the market is looking through the current earnings recession and pricing in 2021 earnings based on optimism that, in time, economic growth will revive earnings. The stock market has already discounted the positive revisions, however, which means stocks could struggle through this earnings season.

Second half performance depends largely on continuing fiscal and monetary responses to the pandemic, further economic improvement, and upward revisions to earnings estimates. The market is susceptible to significant change to any of these variables. At the same time, the U.S. economy must continue to open up for economic fundamentals to catch up the stock prices.

Multiples will remain elevated, which is not grossly incongruent in a zero interest rate environment and a potential acceleration of earnings per share growth. Right now, the median S&P 500 stock trades at 20-times forward earnings, which is a multiple at the higher end of its range, but not extreme, given low corporate debt yield used to discount future cash flows, muted insolvency risks, low inflation, and earnings projections coming to fruition.

Is the S&P 500 vulnerable to a correction after such a strong rally? July tends to be a strong month for the stock market, followed by its weakest period August through October. I believe that the current supply of cash and caution (hedge-fund positioning and traditional institutional exposures suggest professionals are not overcommitted to stocks in leveraged or momentum strategies) is ample enough to keep equity pullbacks from growing too deep for now. This kind of caution is a healthy for market. The market needs a wall of worry to climb for it to advance orderly. I would suspect a pullback or correction to occur if President Trump’s re-election looks in doubt. Also, fiscal stimulus is waning, so the economy may be vulnerable to a slower recovery without additional fiscal stimulus, given lock downs persist and CV cases do not peak this quarter.