Acumen’s Q3 2020 Market CommentaryOctober 10, 2020
The third quarter of 2020 continued this year’s narrative of dynamic financial markets and a recovering global economy. The S&P 500 ended the quarter up nearly 9% after retreating from a new all-time high on September 2nd where it was up more than 15% for the quarter. What happened during the month of September gave many investors pause when a 10% correction came during one of the greatest equity market rallies anyone has ever seen. Throughout the third quarter, we were still receiving positive data on the economic front. Weekly jobless claims declined from the June average of 1.5 million to an approximately 870,000 average in September. The unemployment rate declined to 7.9% (as of 8/31/2020) – a sharp decline from the 14.7% rate witnessed during the second quarter, and even lower than a year and a half after we began recovering from the Great Financial Crisis.
An incredibly sharp rebound occurred during the third quarter as some consumers, who were flush with cash from trillions of dollars in fiscal and monetary policy response, met a now reopening economy. The upside surprise of economic data began slowing toward the end of the quarter as we better understood just how the sudden stop in economic activity had affected us. Economists revised their 4Q2020 GDP numbers upwards, as well as their 2021 numbers, to reflect a current situation not as bad as the 35% stock market decline assumed in March and a reason to begin focusing on where we go from here. When we began re-evaluating our current situation with a better understanding of when we might receive a vaccine, how the pandemic has affected the consumer, and what reopening the global economy looks like, investors noticed stocks had outpaced themselves while looking down the barrel of a very uncertain election season. Sentiment indicators, like the Put/Call ratio which measures investor bullishness and the VIX Volatility index, had reached extreme levels of optimism. We believe the pullback witnessed in September was more likely a slowdown and resetting of investor sentiment after a 60% rally. It was difficult to rationalize new highs in equity prices during what is probably the most uncertain election season we have faced.
We do not believe the rebound is unwarranted or irrational. The rate of change of the global economic data we have analyzed still speaks to a newly formed economic expansion. Things are not “back to normal”, but they are getting better, and this is a reason to be optimistic on riskier assets like equities in the long term. In our view, equities may be fairly valued on an absolute basis when using historical levels, but they are attractive when relatively valued to fixed income. One measure we often use as a relative valuation tool is the Earnings Yield on the S&P 500 compared to the 30-Year Treasuries and the Aggregate Corporate Bond Market. The current forward earnings yield on the S&P 500 is close to 4%, while the earnings yield on a 30-Year Treasury bond is closer to 1.4% and the earnings yield on the Bloomberg Barclays Aggregate Corporate Index is 2.02%. We believe this relative attractiveness is a large reason investor are more willing to invest in more expensive equities than they have historically.
We further believe this environment calls for more active rather than passive management. The crowdedness of the current equity market, the election environment, and the monetary and fiscal policy response we saw during the pandemic lead us to believe investors will have to be much more focused and thematic than they have in the past. The pandemic and the recession it caused is likely to change many dynamics about our global economy. One of the dynamics we expect to continue is the pursuit of deglobalization. We also believe the pandemic has likely exacerbated our greater reliance on technology, especially amidst a new work from home movement. Also, the policy response has driven fixed income yields to the floor while flooding the economy with liquidity – likely pointing to a new normal for monetary and fiscal policy. Our research has shown the political party controlling the White House does not have a correlation to forward equity market returns. Therefore, we do not believe in basing an investment thesis primarily on which party wins the election. However, there are many changing dynamics we face as a nation giving us better insight to how our future economic landscape will likely be changed when viewing the policy. Additionally, we get a better idea of which policy changes are likely to happen no matter which party has control. For example, while Donald Trump has not crafted policy around the implications of climate change, it has become much more of a bipartisan issue than it has in the past. This bipartisanship leads us to believe further investment decisions will have to be crafted around oil and gas exposure. Another example is the likely new normal in fiscal and monetary policy, and we believe the implications of this change are greater inflationary pressures moving forward.
The financial markets are incredibly dynamic and must be monitored on a continuous basis to better understand the probabilities of what is to come. From our research, we have attempted to focus our investment thesis moving forward on a few key themes:
- The fiscal and monetary policy brought about by the Coronavirus pandemic has likely changed our economic landscape. The response is a primary reason why the current recession has not been as bad as it could have been, and why we believe a cash-flush consumer that meets disrupted supply chains will produce greater inflationary pressures moving forward. This pressure is one reason we have increased both international equity exposure and alternative asset exposure through gold.
- Our reliance on technology will only be exacerbated by the pandemic and more socially distanced future. However, we believe investors are likely to find better returns and lower risk outside of more crowded equity trades like Facebook, Amazon, Apple, Netflix, and Google (FAANGs). We believe new economic recoveries bring about great disruption and technological advancements, and investors should be positioned accordingly. Internet and healthcare disruption are two thematic exposures we prefer.
- A 40-year bull market in bonds has led to interest rates settling at all-time lows. Spreads to risk-free rates in Corporate Credit and High Yield have even corrected to their historical averages. While we believe exposure to bonds is important from a portfolio construction aspect to decrease risk, our long-term outlook on bonds is not as optimistic from an investment opportunity perspective.
Acumen’s thoughts on the chart above:
Equities – Most equity indices have risen significantly since the bottom occurred in March. This increase has led many investors to be weary of future equity prices. While we believe near-term volatility will persist due to election concerns and froth from a crowded trade, the long-term fundamentals are sound as the beginning of a new economic expansion is underway and the relative valuation to Fixed Income is attractive.
Fixed Income – A 40-year long bull bond market, coupled with expansionary monetary policy, has led rates across the world to the zero bound or, in some cases, even into negative territory. The United States Federal Reserve policy rate is now at 0.25% and riskier fixed income investment spreads have normalized to their historical average. A dynamic has been created where many investors are receiving a negative return when adjusted for inflation from investment-grade fixed income. We continue to believe fixed income should be implemented across portfolios in the long term to serve as a ballast during volatility, but also believe investors can find further diversification through other assets with positive real rates of return.
Alternatives – With historically higher valuations in the equity market and a more crowded trade across some sectors, as well as negative real yields across many areas of fixed income, we believe investors will be pushed to find alternative investment sources. With inflation pressures and investor uncertainty, gold and its positive correlation is an attractive opportunity in our opinion; given we do not foresee a slowdown in inflation expectations or the monetary policy response which has contributed to them.
Cash – Current inflation expectations lead us to believe investors should not currently have a large allocation to cash and, instead, should put cash to work in a currently dislocated financial market.
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Information used in this commentary was obtained via Bloomberg L.P.
Political policy information obtained from https://graphics.reuters.com/USA-ELECTION/POLICY/ygdpzwarjvw/ and https://educationvotes.nea.org/presidential-2020/biden-vs-trump/
The opinions expressed in this commentary should not be considered as fact. All opinions expressed are as of the published date and are subject to change. Information contained herein is not and should not be construed as an offer, solicitation, or recommendation to buy or sell securities. Investments in securities involves risk, will fluctuate in price, and may result in losses. The information has been obtained from sources we believe to be reliable; however no guarantee is made or implied with respect to its accuracy, timeliness, or completeness. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation. Comments concerning the past performance are not intended to be forward looking and should not be viewed as an indication of future results. Diversification does not protect against loss of principal.
The S&P 500 Index is widely regarded as the best single gauge of the U.S. equities market. The index includes a representative sample of 500 leading companies in leading industries of the U.S. economy. The S&P 500 Index focuses on the large-cap segment of the market; however, since it includes a significant portion of the total value of the market, it also represents the market. The Volatility Index, or VIX, is a real-time market index that represents the market’s expectation of 30-day forward-looking volatility. The Bloomberg Barclays Aggregate Bond Index is an index used by bond traders, mutual funds, and ETFs as a benchmark to measure their relative performance. The index is broadly considered to be the best total market bond index, as it is used by more than 90% of investors in the United States.
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