Top Weekly Themes
Stocks pull back after reaching all-time highs – On September 2, U.S. equity markets reached record levels, but have since declined in four of the past five trading sessions, thus falling 7% as of last Friday morning. However, the resilience of stocks cannot be overstated, given that the S&P 500 Index rose a staggering 60% from its trough to peak levels. Positive earnings revisions, in conjunction with unprecedented support from both monetary and fiscal policy, have played a large role in the rally over the past few months. However, rapidly rising P/E ratios, or the price investors are willing to pay for a dollar of earnings, have accounted for a large portion of the gains that have been realized. In fact, valuations have reached levels last seen during the late 1990s and early 2000s. This is not to say today’s market is a replica of that period, but we do believe investors have become somewhat complacent. Although volatility may persist in the near term, we don’t think the recent retracement forebodes a more significant decline. First, TINA (or There Is No Alternative to stocks) seems firmly in play. For example, making the conservative assumption that the S&P 500 dividend yield remains flat at 1.6% over the next 10 years, with a current 10-year treasury yield of 0.68%, the S&P 500 would have to fall 9% over the next 10 years to equal the return of holding a 10-year treasury note. Further, as the economy continues to improve, which we think is likely over the next 12-18 months, it could create opportunities in some asset classes (i.e., small cap, domestic value) that have dramatically underperformed in 2020.
High momentum growth stocks have borne the brunt of recent selling pressure – The five largest stocks in the Russell 1000 Growth Index, which have displayed strong price momentum over the past 12 months, each fell more than 10% since the recent selloff began. Is the long-overdue rotation from growth to value finally taking shape? We obviously don’t know for sure, and there have now been seven short-lived rotations in 2020 from growth to value. Primarily due to the uncertainty that remains related to the labor market and corporate earnings, we’re not convinced that the seventh time is the charm for value. However, the near-term correction in growth and technology stocks may have more room to run. Despite the recent decline, QQQ (Nasdaq 100 ETF) is still trading at more than 15% above its average price for the preceding 200 days. A test of that level would certainly not be out of the question. Looking out into 2021, we expect that this rotation out of tech stocks will become more sustained as clarity returns to the economic, earnings, and political backdrop.
Fixed income markets are not corroborating the recent move in equities – The interest rate for 10-year Treasuries has held steady during this recent bout of equity market volatility. During the equity market pullback in June, and the more severe decline in March, bond prices rallied (rates declined) as stocks fell. This is typical as investors often seek safe-haven investments at the expense of riskier assets. We would be more concerned if equity markets were falling as bond yields were dropping. In addition, high yield credit spreads have been hovering around 500 basis points and have not materially widened, which is a common occurrence when stock prices fall. Last Thursday, the Bureau of Labor Statistics released Producer Price Index (PPI) data for August, which exceeded consensus estimates. However, this news had little impact on interest rates. We still believe that there is a greater risk of deflation versus inflation until there is material acceleration in M2 velocity.
|Equities||Week (%)||YTD (%)||1-Year (%)||3-Year (%)||5-Year (%)||Div Yield (%)|
|Russell 1000 Value||(2.2)||(11.5)||(4.9)||11.9||42.7||2.60|
|Russell 1000 Growth||(4.5)||21.5||34.1||78.9||138.5||0.80|
|MSCI EM (Emerging Markets)||(2.1)||(0.7)||10.5||8.0||54.5||2.28*|
|Bloomberg Barclays US Aggregate||(0.4)||6.9||7.6||15.8||23.6||1.15|
|Bloomberg Barclays US High Yield – Corporate||(0.4)||1.4||3.9||14.9||35.5||5.54|
|Bloomberg Barclays Municipal Bond||0.0||3.3||3.7||12.4||21.8||1.32|
|Bloomberg Barclays Global Aggregate x US (Country)||(0.3)||4.9||5.1||7.5||20.4||0.78|
|Crude Oil WTI (NYM $/bbl) Continuous||(9.8)||(38.9)||(35.0)||(21.4)||(18.8)||37.3|
|Natural Gas (NYM $/mmbtu) Continuous||(6.6)||6.1||(10.0)||(19.6)||(13.4)||2.3|
|Gold NYMEX Near Term ($/ozt)||1.4||28.6||31.1||45.2||76.1||1,954.2|
|Copper Cash Official LME ($/mt)||1.5||9.0||16.9||(1.0)||24.3||6,710.5|
|Currencies||1 Week Ago||YTD||1-Year Ago||3-Years Ago||5-Years Ago||Current Level|
|U.S. Dollar per Euro||1.18||1.12||1.10||1.20||1.12||1.19|
|Japanese Yen per U.S. Dollar||106.24||108.68||107.29||107.91||120.82||106.18|
|U.S. Dollar per British Pounds||1.33||1.32||1.24||1.32||1.54||1.29|
Chart of the Week
Small Business Optimism and Market Implications
NFIB Small Business Index: Twenty-Years Ending 8/31/20
- Similar to other organizations, such as the Institute of Supply Management (ISM) that attempt to gauge business sentiment, the National Federation of Independent Businesses (NFIB) summons thousands of companies and compiles survey data pertaining to topics such as employment, credit trends, and earnings growth to name a few. Unlike ISM, NFIB focuses specifically on smaller businesses. A score of 100 is a neutral reading and value in the mid 90s or below is indicative of weak or decelerating growth.
- Why do we monitor the NFIB Small Business Index? Small businesses account for roughly half of all private payroll jobs in the United States1. Given that the Paycheck Protection Program (PPP) loan application deadline expired over two months ago, it is encouraging to see that the NFIB Small Business Index rose in August. The hiring/employment segment of the Index showed a material improvement from the previous month. This is just another macro indicator that illustrates the economy is gradually improving.
- We analyzed the returns of large cap (S&P 500 Index) and small cap (Russell 2000 Index) over the past 25 years, ending August 2020, and compared them to the monthly change in the NFIB Small Business Index. Small cap stocks outperformed by an average of 0.16% per month when the small business index exceeded the previous month’s level. The opposite was true when the index fell from the prior month as small caps trailed by an average of 0.19% per month. While no two economic cycles are perfectly alike, small business index readings topped out at levels higher than where they are currently. A positive development on the macroeconomic front, such as a COVID-19 vaccine, will likely raise business confidence and enable small caps to close the performance gap on their more expensive large cap brethren.
Returns of Cyclical Sectors Have Diverged
Cyclical Sector ETF Returns: 3/23/20-9/10/20
The four cyclical sectors (Materials, Industrials, Financials, Energy) referenced in the chart above, which collectively have large weights in value indices, rallied sharply off the March 23 low through early June. All 4 sectors outperformed the broad market as measured by the S&P 500 Index. However, over the past 3 months, returns have been more of a mixed bag with Industrials and Materials faring much better compared to Financials and Energy.
Industrials and Materials have continued to rally as economic conditions have improved, while Financials and Energy, which are materially impacted by interest rates and commodity prices, respectively, have failed to keep pace. The amount of portfolio exposure to the largest five stocks (Facebook, Amazon, Apple, Google, Microsoft) would have clearly been a major factor in keeping pace with the market. In addition, selective exposure within the cyclical space has had a material effect on relative results. This dynamic has not drawn as much attention by investors.
A modest improvement in the economy from this point going forward would likely accompany a steeper yield curve and a decline in loan loss provisions. The market is arguably underestimating this scenario, which we think would provide a considerable tailwind for Financials and value-oriented investors, in general, going forward.