Cautious but Opportunistic

Following one of the quickest and sharpest drops from February’s all-time high to a bear market, U.S. equities staged an impressive run from their March lows to finish the second quarter up 20%.  The S&P 500 logged its best quarterly gain since the fourth quarter of 1998 thanks to the aggressive monetary and fiscal policy response to help fight the current health crisis, as well as eyeing rebounding economic statistics as states began their re-openings.

The surge in the stock market during the quarter exceeded our expectations, as we envision improvements in economic activity may be more gradual, and take somewhat longer, than current consensus seems to expect. Given this economic shock is far worse than any other in the post-war era, it’s difficult to expect equities will “get away with” a mere one month bear market. A more conceivable scenario is for some more speed bumps along the way, affording us the opportunity to add to risk assets selectively during periods of dislocation.

We believe a slowing in the spread of the virus will be needed for stocks to stage a lasting recovery. While this was occurring in April and May, in recent weeks case counts are once again on the rise in more than half of U.S. states, leading to a pause-or in some cases even a dialing back- in reopening plans.  We have seen this resurgence reflected in investor positioning, as stocks levered to e-commerce and work-from-home priorities are once again outperforming as the quarter came to a close.  With broad availability of a vaccine unlikely before mid-2021 at the earliest, the economy likely faces a year of constraint from social distancing.  This restraint, along with significant uncertainty in the path forward, has us leaning cautiously on the equity market’s prospects from current prices.

With June quarter earnings on deck, we believe this season will be critical in establishing a base from which we can begin to forecast an earnings recovery.  This quarter is expected to mark the low, but it is the trajectory of the recovery that remains highly uncertain given that company guidance is at all-time lows. Following last year’s S&P 500 earnings of $164, a 30% decline in 2020 would leave us at $115. A 30% recovery for 2021 results in $150.  A 1-yr forward P/E multiple of 19x, greater than its long-term average given record low interest rates and narrowing credit spreads, results in 2,850 for the S&P 500. 

However, given the outsized impact of sentiment right now with fundamentals in flux, our fair value range for the S&P 500 may be a more appropriate way to view the current opportunity, which remains in the 2,600-3,300 range. Pullbacks towards the lower half of this range provide solid total return potential for long-term investors.  Of course, markets can overshoot fundamental value estimates and remain stretched for long periods of time as well.

The difficulty for market participants is that valuation rarely matters in the short-term, as fear and greed is what drives markets. After a recent period of improved sentiment as mindsets shifted from “it will get worse” to “it will get better”, we may be starting to see a reversal back to some caution.  If so, it may provide us with investment opportunities as we take the longer-term view.

Sector Outlook

While we are guarded on equities right now, we are not blind to opportunities that are presenting themselves and with interest rates at or near historic lows, the alternatives for investor capital provide little in the way of attractive total return.  Certain cyclical stocks and sectors that require stronger economic growth have attractive valuations, but there are risks due to the uncertain timing with respect to an economic recovery, such that they may get even cheaper still and remain volatile. 

From a sector perspective, we continue to favor Technology and Health Care, but have moved our previous Industrials overweight back to neutral largely due to a more cautious view on the macro recovery that we believe increases the risks in the sector.  Technology continued to outperform during the quarter, benefiting from the “shelter-in-place” remote work environment, and resilient trends in software spending. Additionally, many technology companies have substantial cash balances, relatively low debt, high recurring revenue, and high margins. 

Health care has a chance to emerge from the outbreak with a better public image as many companies have rallied to fight the virus. The sector should remain more resilient during this recession. However, if the virus exerts a sustained impact on the economy with significantly higher numbers of unemployed, uninsured, or underinsured patients, this could be a headwind to demand.  The upcoming election may also present a risk to the sector, particularly around drug pricing policy given bipartisan support.

Industrials underperformed during the second quarter advance, and we have become more cautious on the sector. The most attractively priced stocks are the deep, cyclically exposed companies that require an expanding economy to thrive.  New orders, production, and pricing are improving following the steepest drop ever during the month of April, but these trends will need to continue to show progress for the sector to outperform. 

We are neutral on Consumer Discretionary and Staples. While breadth in the Consumer Discretionary sector has improved, it is primarily being driven by Amazon which represents almost 40% of the sector. We believe several best in class operators will be long-term share gainers at the expense of cheaper rivals, and we were able to take advantage of the sell-off during the quarter to add a few of these companies to our portfolios.  Within Staples, we believe more upside is available in other sectors as the economy slowly recovers from COVID-19 and consumer cocooning ebbs.

We remain underweight Energy, Financials, and Communication Services. With the Energy sector now less than 3% of the S&P 500, we are being very selective with our stock selections.

Financials remain challenged given that two of their primary earnings drivers- a steepening yield curve and credit spreads- have been deteriorating because of the global shutdown brought about by the pandemic.  The severity of unemployment, elevated credit costs, and rising bankruptcies are risks that could take several quarters to become apparent, keeping valuations depressed.  We are sticking with best of breed names only at this time.

Finally, Communication Services is a challenged sector, as many telecommunications, entertainment, and media stocks face challenging industry fundamentals that include slower growth, higher costs, and increased competition.

Key Takeaways

The recent stock market volatility can feel overwhelming, from the depths of despair three months ago, to be quickly followed by a near-record recovery off the lows.  There is nothing normal about this cycle, as we have never seen a health crisis morph into an economic one as governments worldwide shut down their respective economies.  In times like these, it is more important than ever to stay disciplined, keep your emotions in check, and make sure to diversify appropriately.  Like all crises, this too shall pass.  For our part, we will continue to focus on best of breed, high-quality companies, with solid fundamentals, selling at attractive relative valuations for your equity portfolio.