Monthly Update for May 2020
Following the sharp market declines seen in February (down 8.4%) and March (down 12.5%), followed by the rebound in April (up 12.7%), stocks continued to rally in May by 4.5%, leaving the year to date performance down about 6% not including dividends. The strong performance in the big cap tech stocks has certainly been a key contributor. Highlighting this, Facebook, Microsoft, Alphabet, Apple, and Amazon make up about 20% of the S&P 500. If one were to equal weight all 500 stocks in the index, thus taking out the large influence of these names, it would be down 13% year to date through May. Separating value from growth has the S&P 500 growth index up 4.4% year to date through May, while the S&P 500 value index is down by 12.7%. The Russell 2000, considered the broad small cap index, is down 16% year to date, even after the rally seen in both April and May.
We believe there are three key reasons why the stock market has come back as strong as it has in light of what is still a difficult economic situation. Firstly, the stock market is focused not on the current economic data where the weakness was self-inflicted, but on the economic reopening, which is unfolding on a daily and weekly basis. Secondly, the extraordinary amount of monetary and fiscal support has helped to boost credit markets, refill the pockets of those that have lost jobs, and assist companies in meeting payroll while closed. Thirdly, due to the aggressive lockdowns, adherence to mask wearing and distancing, mass testing and improved medical techniques in treating patients, we seem to have our arms around COVID-19. Yes, this virus will likely flare up again in the fall, but it seems that we will be much more prepared in dealing with it.
The Stock Market
I laid out above the reasons for the strong snap back in equities. The question, then, is what comes next. I think the key determining factor will be how things look after we reopen; most things such as large gatherings, such as sporting events and concerts, will occur in 2021. To what extent have businesses reopened? How many of the existing staff will be brought back? What are consumer spending intentions going to be? Will we see pent up demand or will consumers decide to save more? To what extent will companies resume the pace of expansion and capital investment? Will they proceed more slowly, or will they quickly restart pre-COVID plans?
The answers to these questions will help determine what the earnings picture will be for corporate America. Looking at the S&P 500 specifically, we see that 2019 was the best year ever for earnings, with earnings per share coming in at about $165. Thus, with the S&P 500 trading around 3000 as of this writing, we are trading at 18 times what is, for now, peak earnings. It could take a few years to achieve that number, which implies the stocks market is even more expensive right now.
The Bond Market and the Federal Reserve
While the stock market is seemingly very optimistic about a global economic recovery, the US Treasury market has more subdued expectations, if we just go by where the 10 yr yield is. The 10 yr yield ended March at .67%. It ended April at .64% and just finished May at .65%. Not much movement there, considering the roaring stock market we have seen. Now, granted, the Fed has been very aggressive with its asset purchases of Treasuries, but it still only explains part of this behavior. At some point, the Treasury market and the stock market need to reconcile the differing views on economic growth.
Speaking of the Fed, they started in May their purchases of corporate bonds, both investment grade and junk. They are definitely crossing a Rubicon with this, as it is not specifically allowed in the Federal Reserve Act. Instead, they did a run around by creating, with the Treasury, a special purpose vehicle that will hold these assets. The acronyms for these programs are PMCCF and SMCCF, the Primary Market Corporate Credit Facility and the Secondary Market Corporate Credit Facility. These programs are in addition to ones that help the commercial paper market, the municipal bond market, the mortgage market and the Treasury market. Lastly, the Fed is about to embark on its Main Street Lending Program, that will help facilitate loans to businesses with less than 15,000 employees and $5b of revenue. As I said in our April letter, “all of this is to grease the wheels of credit and increase the level of lending to buy businesses time to when the economy improves. The question remains, though, can all this liquidity cure what is seemingly a solvency problem?”
The economic decline we saw in Q1 of 5%, and will be much worse in Q2, possibly as much as a 35% decline, was all self-inflicted. We decided to shut things down in order to contain the virus. It functioned to do so, but at an extremely high cost. Thankfully, more businesses are reopening on a daily and weekly basis, but to what extent will determine what economy we are left with. Therefore, do not pay attention to the current economic headlines. Let’s wait until July and August, after most things have reopened, before jumping to conclusions about the state of things. We can certainly say that about the global economy, as many things are reopening everywhere.
As to what things will look like, watch China, South Korea, Singapore, and Taiwan, as these countries have kept the virus contained and have reopened most things. Over the past few months, Singapore did have a big flare up, but it was solely isolated to dormitories that house migrant workers. I want to mention Hong Kong in particular, as in a city of 7mm people, only 4 people have died. That is because they learned many lessons after SARS in 2002-2003, and quickly adjusted in January when they heard about the virus spread in China. Mask wearing is a key tool they’ve used. Wear one.
In order to fill the economic holes caused by the forced economic shutdown, the US government passed the CARES Act in March (Coronavirus Aid, Relief and Economic Security Act). A key part of this was the Paycheck Protection Program, whose initial funding ran out, but was then refilled. Congress is on the cusp of extending the program for a few more months and will give businesses more leeway on how they allocate the funds.
The current expansion of unemployment benefits, which added an additional $600 per week on top of existing state level benefits, does expire on July 31st, and the question is whether they will be extended. If they are, they will most likely be reduced as we try to encourage workers to get back to work, if the jobs are available.
After the world turned upside down in March and April, we are slowly trying to normalize our lives. Businesses are reopening, the virus numbers have slowed dramatically, testing is widespread, and summer is coming. However, we still must be smart with mask wearing, keeping our distance, washing our hands, etc. as the virus is still out there.
The economy will improve in the coming months, as businesses reopen, and consumers gain confidence in going outside and shopping again. The latter will take time, but hopefully we learn to acclimate to our new reality until effective therapeutics and/or a vaccine is discovered.
This is a difficult time, but we will get through it. Of particular importance for clients is making sure they have their short term liquidity needs met over the coming 24-36 month period, which then makes market volatility less relevant during this time frame.
Please do not hesitate to reach out at any time with questions or for any discussion on the economy and markets.
 Federal Reserve
 Johns Hopkins