May 2020 Snapshot
The month of May brought higher returns in both equities and fixed income which may seem counterintuitive given all the bad news we witnessed on a daily basis from COVID deaths to economic destruction. The monthly returns were also much more broad-based with participation across various asset categories, sizes and regions as seen on the first column, 1-month returns, in the above chart. Small and mid-cap stocks that had not participated to the same extent as large caps were strong in May. Additionally, value sectors such as materials and industrials participated in the May rebound. Emerging markets (EM) were the weak spot during the month with a modest 0.8% return. As we noted in our April monthly review, Sandy Cove Advisors has removed Emerging Markets from our asset allocation and sold most of the EM positions in our clients’ portfolios. COVID-19 cases are still rising in most emerging counties with India and Brazil (over 30,000 cases per day) notable areas of concern. Renewed China-U.S. tensions will also not help the region economically.
Is the market too optimistic at this point? This is a much-debated topic, with strong points on either side of the argument. On the positive side, the U.S. has moved past the worst of the virus (for now), the economy is beginning to re-open, the U.S. government has swiftly created monetary and fiscal stimulus to help, and we are reporting progress on COVID-19 solutions, to name a few. On the negative side, we are at record unemployment and record low economic indicators, we do not have a cure for COVID-19 yet, large cap U.S. equities look expensive, we do not have visibility on demand recovery, or how we’ll deal with a resurgence of the virus if it returns in Fall 2020.
Additionally, it’s worth noting that the current composition of the stock market (S&P 500) does not always represent the economy. The chart below is a great visual of this fact. To date, the large tech companies – Microsoft, Amazon, Apple, Google, and Facebook – have greatly outperformed the broader market due to their “stay-at-home” advantages. Today these firms represent 20% of the S&P 500 Index, yet the combined revenues of these 5 tech companies amount to only 4% of total GDP.
Large Tech has Low Economic Footprint Relative to Market Cap
Sandy Cove Update: Slowly Moving into Small and Mid-Cap U.S. Equities
We are making a small change to our asset allocation. Since early March, we’ve been reluctant to put cash to work into equity markets. Stocks continued to fall during March due to COVID-19, but large cap stocks (mostly mega-cap tech names) have staged a strong bounce off the bottom. The rest of the market has not participated in the same fashion.
While we are not giving the “all clear” sign for the entirety of equities, we are getting more comfortable dipping back into specific areas of stocks, namely mid and smaller cap U.S. equities. We still believe the domestic large cap equities have rallied too fast and are set for a pullback. The S&P 500 is up 36% from the trough and down only -5.0% for the year as of May 31st. However, mid cap and small cap indices are still down -11% to -16%, respectively year-to-date. We are intent on buying actively managed funds where portfolio managers and industry analysts are carefully selecting stocks that they believe can weather the storm and come out the other side successfully. The cash being put to work to rebalance in these two asset classes is modest (about 4% in most portfolios) and was raised from our March/April sales in emerging markets and real estate.
While there are still unknowns on our check-list for the road to recovery, we think the risk-reward to investing in the mid/small part of U.S. equities is attractive here. We will be making these trades in the near future.
The S&P 500 has rallied more than 36% from the March lows, further reinforcing the concept of staying invested and weathering the dips. This rally has also largely rebalanced clients’ portfolios back to their target large cap allocation. Diversification is also benefiting clients’ portfolios. A 60/40 allocation has preserved capital better than the S&P 500 this year. The graph below shows a flat BlackRock Target 60/40 Allocation fund against the -4.0% return for the benchmark for U.S. equities.
BIGPX 60/40 Fund (blue) versus S&P 500 Index (green) Year-to-Date Return
The charts below show the major S&P 500 dips since 2010. On the top half, you see the dips in prices circled. The bottom half shows the correlating volatility reading of the market (VIX Index) during those dips and the reasons for the price moves. This correction is notable in many ways: the VIX Index broke out to a new high and the magnitude and speed of the decline and subsequent recovery is one for the record books. The bigger picture conclusion to draw is that staying invested in your asset allocation is wise over the long-term as all previous dips in the past 10 years have resulted in new highs over time.
Source: J.P. Morgan
The Fed has been incredibly successful at fixing “broken” bond markets in March. In a television interview, Fed Chairman Powell said the Fed remains committed to helping markets saying, “we’re not out of ammunition by a long shot.” During May the yield curve steepened slightly as the 30 Year Treasury rose 13 bps to 1.40%, see table and chart below. The short end of the curve (1 – 10 year) was little changed from April.
Source: Baird Advisors
With economic re-opening optimism, spreads have tightened recovering from March/April. Diversification is again working well (quality is leading and junk bonds lagging). Investment grade corporate spreads have recovered about 75% of their widening since March, providing a much better environment for corporations to access capital which they did to the tune of $286 billion worth of issuance in the month (a near record).
According to J.P. Morgan, during the COVID-19 panic phase in March, investors pulled over $1.5 trillion out of both equity and fixed income markets and parked it mostly in money market funds (cash proxy). Not all of that cash may make it back into the markets as, but it’s a powerful demand force on the sidelines right now that could soften any future market declines.
Don’t Fight the Fed
We wrote about this in April and are repeating it again this month because we think this is an extremely important reason why markets are at the levels they are today. Monetary stimulus is a powerful tool, the speed and amount ($10 trillion in 4 weeks) that the U.S. government deployed to bridge the chasm of our shuttered economy gave markets hope it would be enough to get us through. And we know that, if needed, more aid is on the way.
The U.S. made good progress over the last 30 days moving the nation from about 30,000 cases per day to about 20,000 as of this writing. The key question is will we see a resurgence in the Fall and, if so, how bad? We do know that we have more tools this time around to better cope with escalating cases.
Daily Cases of COVID-19 in U.S.
Source: Johns Hopkins University
Not only are many experts at odds over why the market has recovered so quickly, but they are also debating what our economic path will look like. Invesco created a good diagram shown below of how the three main camps of thought look on macro scenarios for the U.S. economy:
We would put ourselves in the middle camp at this point. The best-case scenario is currently unrealistic since most states have closed down economies for over two months and the pace of opening is cautiously slow. We also note this is an important election year for Congress and the White House which usually gives the markets pause.
We continue to hope that an economy slowly moving back to normal will get us headed in the right direction. As always, please reach out to any Sandy Cove Advisor colleague with questions or concerns.