"Truth is stranger than fiction, but it is because fiction is obliged to stick to possibilities; truth isn't."
Mark Twain

2020 has been remarkable on many levels. As Mark Twain famously says, reality can provide a far broader range of outcomes than fiction. The second quarter saw stocks have their best quarter since 1998. This is on the heels of the fastest bear market in history seen during the first quarter. This leaves the S&P 500 down 3.1% for the year and it is 7.7% from the previous highs seen in late February. All major stock indices posted double-digit gains this quarter and technology stocks were once again the best performing sector. Bonds were positive during the last three months with a return of 2.9%.

Most conversations I have had recently seem to start with, why are stocks rallying when things are so unsettled? It is a great question and we'll try to unpack it. Most people are talking about the economy when they mention that things are unsettled but we recognize that this is also tied to COVID 19 and social protests taking place around the world. We'll focus on the stock market and economy since that is our area of knowledge. The stock market and economy are linked but do not move in perfect sync. Economic data is backward-looking because the information is always gathered from a few weeks, months, or quarters in the past. The stock market tends to be more forward-looking. Investors discount future expectations and extrapolate them into prices today. This is why the stock market is usually trending up before the economic data is improving.

The other reason the market has rallied is because of the unprecedented action by the Federal Reserve (Fed) and the US Government to provide stimulus to the economy. The rollout has not been perfect but the speed and size of their actions have pushed many investors into stocks. The Fed is using some of its programs created during the financial crisis to buy corporate bonds and mortgage-backed securities. They have also pledged to keep interest rates near 0% until the COVID crisis has passed. Investors have moved back into stock in order to earn a better rate of return. The saying "Don’t fight the Fed” still applies and because of the Fed’s actions, stocks are likely the least bad option for investors given the low rates of returns available in bonds.

Investment Strategy

In early April, we reinvested the cash we raised in the first quarter. We increased our holdings in the US Small Cap stock as we discussed in our last Viewpoints. Small Caps were one of the better performers in the second quarter. We are still holding about 5% in cash and money market funds. We are positive on the markets but want to have some flexibility in the second half of the year.

Outlook

We remain optimistic on stocks over the long term, but let’s look at some historical comparisons for the next few months and the remainder of 2020. Given the unusual times, history is providing some mixed signals. When markets rally 15% or more in a quarter, the next quarter has been positive in all nine instances since World War 2. The average rate of return is 9% with the lowest return being 4%. Looking at first half data since 1928, when stocks have a negative return at the halfway point, they generally have below-average returns for the rest of the year. The average return when stocks are down in the first half of the year is 0.7%. History is not an excellent guide for the rest of the year but it does provide some context.

Guess what; there is an election this fall. This is the elephant in many peoples mind but most investors won’t start positioning their portfolios until closer to the election. The biggest takeaway is markets are usually pretty calm and range-bound during the summers in election years. Volatility starts to pick up in the weeks closer to the election. You can read our article, How Do Stocks Perform In Presidential Election Years? to dig deeper into this topic.

We’ll take a look at the knowns and unknowns and how they are impacting our outlook. In the known column, we’ll talk about economic trends and market valuations. The economic trends are improving faster than expected. Wall Street expected a snapback of the economy because of the unique nature of the COVID Recession. Things are improving more quickly than expected with unemployment and consumer spending bouncing back but we are still a long way away from prerecession levels. The S&P 500, our stock market proxy, is trading at 21.7x the next twelve months' earnings. When stocks were at their peak in February, the market was trading at 19 times forward earnings. The past 25-year average is 16.4x. So stocks are rich historically but is this a reason to sell stocks? Our answer is no. Stocks look expensive now because of a few factors. Earnings will be better for the full 2021 year, 2022, and beyond. When things normalize, the P/E ratio should drop. Additionally, with interest rates low and expected to remain low this does mean we should expect to see valuations run at above normal levels.

The two biggest unknowns are, have the Fed and US government provided enough stimulus to bridge the economy until there is a vaccine or treatment for COVID and when will a vaccine be widely available? Let’s tackle the latter first. There has been positive initial results from several vaccine clinical trials. The market is pricing in that a vaccine should be available by early to mid-2021. This could prove to be optimistic or right on. It remains an unknown. Has the Fed and US government done enough to get the US economy through this? Right now it looks positive, but there are hurdles ahead. Many individuals have been able to defer loan payments for months and have received a stimulus check from the government. Once the stimulus money has been spent and loan payments are back to a normal schedule, how is this going to impact consumer spending and sentiment? We expect there to be some bumps in the roads as things normalize.

Our long term view is that stocks are still an attractive investment. Valuations are rich but we are comfortable with our current investment outlook given our belief that 2021 should prove to be better than 2020.

Disclaimer: The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.

US Viewpoints: June 30, 2020