June 26, 2020
Making Cents of the Markets
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Be in the Know
Today saw another bout of Friday selling and the markets’ 2-3% retreat resulted in giving up last week’s gains as COVID-19 fears multiplied. Some of the most populous states this week are reporting record daily infection increases as they attempt to re-open the economy. Today, Texas Governor Abbott halted the re-opening process after experiencing a record increase in new cases this week throughout the state. Under the new guidelines all bars state-wide were ordered to close again in addition to reducing restaurant capacity to 50% while in Florida, Governor DeSantis’ ordered all on-premises alcohol sales are to cease until further notice.
Further adding to today’s negative sentiment was the latest results of the Fed’s stress test on banks. The Federal Reserve has announced that banks are strong enough to weather the coronavirus pandemic. However, according to the report which tests banks stability under a hypothetical economic crisis devised by the Fed, some banks could get close to minimum capital levels in scenarios related to the coronavirus pandemic. The solution to the risk is that banks are now capped to what they paid in Q2 dividends for Q3 this year essentially eliminating dividend increases in addition to not allowing share repurchases. As a result financials were one of the hardest hit sectors today.
As a bellwether for the US retail sector, Nike shares fell more than the market on the back of a surprising quarterly loss for the apparel giant. Nike’s quarterly revenue reflected a drop of 38% on a year-over-year basis. Online sales, which represent nearly a third of total revenue, surged 75%, but that was not enough to make up for the temporary coronavirus-closures of its stores. Some companies are seeing better sales volumes and have the ability to benefit from current conditions more than others, highlighting the need for a higher level of due diligence in stock selection.
It’s no surprise that personal income is lower than last year but it is slightly better than expected and spending has rebounded, though we question how sustainable it is. US data showed that income fell -4.2% vs -6.0% expected and spending which accounts for 2/3 of the US economic activity, rose 8.2% last month. Earlier this morning, ECB President Christine Lagarde said the recovery from the coronavirus pandemic will be “restrained” and will change parts of the economy permanently. While the worst of the crisis might be over, she stated that it’ll take time for the “phenomenal” jump in savings to trickle into higher investment and spending.
Oil prices are lower despite satellite data showing strong pick-ups in traffic in China, Europe and across the US which pointed to a recovery in fuel demand. However, there are fears a spike in COVID-19 infections in southern US states could stall the demand recovery, especially as some of those states, such as Florida and Texas, are among the biggest gasoline consumers. The prospect of increased US crude production also kept a lid on gains. A survey of executives in the top US oil and gas producing region by the Dallas Federal Reserve Bank found more than half of executives who cut production expect to resume some output by the end of July.
We saw a strong rebound from mid-May to June 8 but the S&P 500 has since been in a consolidation phase since then, currently trading right around its 200 DMA support level. While an increase in cases was inevitable in our view, the increasing number of hospitalizations and percentage of tests coming back positive are concerning. Monitoring hospitalizations will be key, as worries over hospital capacity will put added pressure on government officials’ decisions in restarting local economies. We are encouraged by improvements in treatments, mortality rates, length of hospital stays, and the potential for a vaccine. However, we expect volatility in the spread in the weeks and months ahead. We continue to believe that we won’t experience a second wave of broad economic shutdowns again, but there are increasing odds of delayed re-openings or reversing reopening steps. This will impact volatility in equity markets, but could also result in further monetary and fiscal stimulus which has been the reason the markets have rebounded.
For now, we view this as a normal consolidation phase following the market’s historic rally off the March 23 lows. If the narrative does not shift from stimulus and the economic restart, we believe the technical support likely holds (1-3% downside from current levels). However, if a more challenging narrative develops (i.e. the virus spread continues to accelerate and concerns on hospital capacity rise), the S&P 500 could push lower.
There is some resistance to upward movement short term in both scenarios. In the longer term path ahead, we believe the positives (namely unprecedented stimulus) outweigh the potential negatives. It makes logical sense for the market to slow down or pause in the short term following such enormous strength off the March 23 lows. Importantly though, historical performance following similar surges out of recessionary bear markets has been very favorable over the next 12 months. This contributes to our positive bias and view that pullbacks should be used as buying opportunities.
Beneath the surface, relative strength from the more technology-oriented stocks are masking the pressure felt by many other stocks in the market’s volatility. While the S&P 500 index is just -5.4% from its recent highs on a couple weeks ago, the average S&P 500 stock is down 12% since then. The more economically-sensitive areas- i.e. small caps, average consumer discretionary stock, industrials, and financials- have all now pulled back to their 50 DMA support. These are also the areas that will be more volatile if the virus spread deepens though. If they are able to hold technical support, we would look to buy partial positions in these more cyclical areas with a long term view.
Chart of the Week
Courtesy of our friends at Bespoke, who have some of the best analysis on the street: “The current drawdown in stocks has been in the “sweet spot” of normal equity market drawdowns between 5% and 10% from recent highs, but it’s come during a large bounce off a bear market low. By that standard, it’s also relatively normal, if slightly larger than we tend to see. In the chart below, we show drawdowns from a high since the lows of bear markets, for the six months after those lows have been established. All data is since 1940. As shown, while the lurch lower from June 8 to June 11 was something of a standout, the current distance from rally highs isn’t at all unusual for post-bear market rallies.”
“Another way to look at things is to compare the maximum drawdown after bear market lows from prior bounces. Again, the current environment looks basically normal by this measure. One interesting thing we do note, though, is that if the market doesn’t roll over to a new 20% decline relative to the bounce highs in the first three months since the original low, it doesn’t do so in the following three months either. That would make the odds of a retest of the old lows unlikely. We would argue that the policy backdrop – both fiscal and monetary – also serves to reinforce that conclusion qualitatively, as does the evolution of COVID. Investors can be reasonably certain that the worst-case scenarios which were possible in mid-March are off the table now because the Federal Reserve and Congress are fully engaged, and our understanding of the virus’ lethality and spread has improved markedly.”
Beyond the Markets
The Government of Canada has released a number of activity packs to help you celebrate this Canada Day while staying safe! The “O Canada” activity pack provides you with recipes that test your cooking abilities including how to make bannock, blueberry cobbler, and space chili. The “Beaver” pack sparks your adventurous side with instructions on how to train like athletes on Team Canada and much more! Browse through the packs here for some great ideas on how to spend this Canada Day!