In this article we review:
- The recent equity sell-off which now has major equity indexes at or near correction levels
- What could lead to further volatility between now and year-end 2020
- Why we believe the longer-term case for stocks remains intact
- Changing Federal Reserve Policy, COVID-19 potential market impacts, recent economic trends, the political backdrop, and other pertinent factors
Major stock indexes have fallen in recent days and, as of the market close on September 8, the NASDAQ has reached full-correction territory as it has declined 10% below its September 2 intraday high, followed by the S&P 500® down almost 6%, and the Dow Jones Industrial Average over 5%. This, in our opinion, is representative of a more volatile short-term environment we could see in stock prices over the next couple of months. Given that the S&P 500 and NASDAQ reached record highs on September 2 and the Dow rose to within 2% of its record high, we suspect stocks could potentially be subject to a further correction in the 5% - 10% range during upcoming months. But we believe that should not be considered unusual or overly concerning to longer-term investors given the powerful rise in equity prices since late March.
The equity markets had experienced an upward move over the past six months of historical proportions as the S&P 500 appreciated more than 60%, and NASDAQ more than 80%, from their March 23 low to their closing price on September 2. While there has been specific and, in our opinion, warranted catalysts and criteria contributing to this dramatic move, anytime markets move that far that fast, there is likely to be short-term volatility to follow. We believe such volatility should be recognized in accordance with the longer-term potential of the equity markets based on the current and unique environment created over these past several months.
Specific events and / or developments potentially contributing to volatility between now and year end could include:
- Technology stock volatility, which has led the recent sell-off. Index declines have been exacerbated these past few days by a relatively concentrated group of technology stocks that have grown to larger percentages of the composites and, following their meteoric ascent these past few months, are now taking the brunt of the sell-off. These include names such as Facebook, Amazon, Apple, Netflix, and Microsoft, which all saw moves of close to or more than double their late March stock prices, but have now individually seen declines ranging from 9% - 16% since last week. We expect technology stocks and, in particular, those leading-price performers since March, to remain volatile in the months ahead.
- COVID-19 infection and fatality trends. While showing some signs of slowing since peak summer months, virus numbers still face the risk of rising substantially as daily case increases remain higher than last spring. In addition, colleges are seeing recent spikes as students return to campus for the new school year. Fatality rates, however, in percentage terms, continue trending lower than earlier in the year.
- Investors and society at large anxiously await medical data on COVID-19 vaccine candidates, which could be released to the public in the coming months. It is important to remember we are yet to see Phase III clinical data on any vaccine candidates, which is the most important information in terms of displaying real, outcome-based efficacy profiles worthy of Food and Drug Administration (FDA) approval. The public release of such data can often have a volatile impact, up or down, on the individual stock prices of companies developing groundbreaking new therapeutic treatments. However, given the impact of COVID-19 on the global economy, upcoming vaccine data will almost certainly affect the broader markets as well.
- The presidential and congressional elections, and how they appear to be shaping up, could also play a key role in market volatility. Between now and November, there will undoubtedly be intense political theater pertaining to both how President Trump and former Vice President Biden exchange campaign crossfire, as well as the background of crucial down-ballot Senate races. For more on this topic, please consult our Special Report: The Election and the Markets.
- The congressional impasse between the parties on additional economic relief could also frustrate investors. Unfortunately, the inability of Congress to come to an agreement on further fiscal economic stimulus remains bogged down in slow-moving negotiations between Democrats and Republicans. Should this situation wear on without evidence of progress toward a new economic package, this could also add to market fluctuations.
- Economic data on third quarter trends will also be hitting the markets fast and furiously. The upcoming weeks will include not only employment numbers for the month of October, but also ISM Manufacturing and Non-Manufacturing Indexes, Retail Sales Reports and, perhaps of greatest anticipation, the first estimate of 3Q 2020 GDP growth, expected to be released the week prior to election day.
With no shortage of short-term factors potentially impacting the markets, we like to remind investors we see several longer-term criteria positioning the markets favorably as we look out over the upcoming year or two. These include:
- The economic recovery appears to be moving faster than originally expected. At approximately the two-thirds mark of this 3Q, the Atlanta Fed is currently estimating annualized GDP growth for the quarter at better than + 29%. This is much higher than expected at the quarter’s outset, and the case can now begin to be made for a full recovery back to 4Q 2019 GDP levels, occurring by the end of 2021. Just a month or so ago, the broad consensus was that such a complete recovery could not be reached until late 2022 or early 2023. Corporate earnings also appear to be recovering ahead of previous expectations, with forecasts now for 2019 S&P 500 operating earnings per share potentially being re-achieved by the end of 2021 (Factset Earnings Insight).
- Employment levels have also been exceeding expectations. Since the loss of 22 million jobs from the U.S. economy during the cataclysmic months of March and April, about half of those losses, more than 11 million, have been regained since May. The unemployment rate, as measured in the most recent August Nonfarms payrolls report, now stands at 8.4%, actually lower than it was in 3Q of 2012 — more than three years into the recovery of the global financial crisis and great recession.
- Accommodation from the Federal Reserve in terms of an extended time frame on zero short-term interest rates seems to have only elongated in recent weeks. In his annual address to the Jackson Hole Economic Policy Symposium on August 27, Fed Chairman Jay Powell announced a “Statement on Longer Run Goals and Monetary Policy Strategy,” signifying a shift in the Fed’s longstanding perspective regarding inflation. Specifically, Mr. Powell expressed the Committee would be moving away from its practice of pre-emptively heading off higher inflation. The end result of this policy shift by the Fed is that they will, in all probability, let inflation run above its 2% long-term target for some time before raising rates.
- What this means, in our opinion, is that the Fed will not be raising rates for an even longer time frame than believed just weeks ago, which was already perceived to be a long period of time. All considered now, we do not see Mr. Powell and his fellow Committee members raising rates any time in the foreseeable future and, likely, a good bit longer than that. Such a rate environment should continue to be a tailwind for stocks.
- Fed monetary stimulus in the form of monthly bond buying should also help to provide ongoing liquidity for the markets. Since March, the Fed has increased its balance sheet from $4.7 trillion to $7 trillion. They are expected to maintain their current monthly rate of approximately $120 billion in Treasury Bond and Agency Mortgage-Backed Securities open market purchases for the indefinite future. All else being equal, this should also prove favorable for stocks and the credit markets.
- Valuations still appear more than reasonable given expected earnings growth and low long-term interest rates. As we have said before, one cannot simply take current stock earnings multiples off depressed levels of corporate profits and compare them to past history in determining whether equities are presently cheap or expensive. We feel a more appropriate method is to look at an expected recovered level of corporate profits and compare that earnings yield to current long-term interest rates still teetering on the edge of all-time record lows. In this regard, an expected CY 2021 S&P 500 earnings yield of approximately 4.9% (3,426 / CY 2021 Factset estimate of $167) less the current 10-year Treasury yield of about 0.72% denotes an attractive entry point by historical standards. With this in mind, we believe equities are well positioned for double-digit annual total returns between now and the end of 2022.
Previously, we have talked about a “Back to the Future Market” in which the economy and corporate earnings scratch and claw their way back to pre-COVID-19 levels. However, once they get there, the interest rate environment and effects of economic stimulus provide for a far more attractive backdrop than before and, thus, higher valuations are justified. In recent weeks, that scratching and clawing has been stronger and faster than originally anticipated and with greater Fed accommodation, the market had reacted extremely favorably — until these past few days, of course. However, with strong short-term returns, such as 60%-plus gains in less than a half-year, comes a higher degree of short-term volatility, particularly as large doses of important news are expected. So expect more volatility as we finish out this historic year of 2020. However, as we see the current landscape, pending roller coaster rides are still moving upward in the long run.
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The COVID-19 pandemic has caused substantial market disruption and dislocation around the world including the U.S. During periods of market disruption, which may trigger trading halts, the fund’s exposure to the risks described elsewhere in the prospectus will likely increase. As a result, whether or not the fund invests in securities of issuers located in or with significant exposure to the countries directly affected, the value and liquidity of the fund’s investments may be negatively affected.
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