Weeks where decades happen

May 20, 2020

Yesterday was a milestone of sorts for the S&P 500 Index, and for most other stock markets, as it capped a three-month period in which the U.S. fell a staggering 34% over 33 days from the February 19th all-time high, only to gain half of it back in the last three weeks. Vladimir Lenin’s quote that “There are decades where nothing happens, and there are weeks where decades happen” aptly describes the feelings of whiplashed investors during this period.

Where do we go from here? In the short term, stocks are nearing a critical level that has acted as overhead resistance to further gains on two previous occasions in the past month. U.S. stocks are again bumping up against a widely watched technical level of 3,000 on the S&P 500 Index, and this level also happens to be its 200-day moving average. While 3,000 and the 200-day moving average carry no fundamental meaning, this level is likely a psychologically important barrier that many investors are closely watching, with the expectation that stocks will turn back at this level or break out past this level to further gains. Since the March 23rd low of 2,237, the market has rallied a long way, but it has been caught in a holding pattern over the past month as it consolidates in a sideways range between 2,800 and 2,950.

S&P 500 Tight Range

Source: Bloomberg

For the S&P 500 to convincingly break through the 3,000 resistance level, the catalyst in the near term will come likely from positive COVID-19 vaccine headlines. But as we saw from yesterday’s late day sell-off as questions emerged about the potential COVID-19 vaccine from biotech company Moderna, these headlines do not produce durable rallies.

Fundamentals won’t be the catalyst to push the market higher. While valuation is a poor market timing tool, the S&P 500 is currently trading at 21x forward P/E, its highest level since December 2000. Stocks are expensive. The combination of estimated 2020 S&P 500 profits plunging by 21% and the strong rebound in stocks over the past month has created high expectations for a V-shaped rebound in profits next year. Of course, the extraordinary monetary measures that the U.S. Federal Reserve has enacted to bring interest rates to zero and the anticipation of a successful COVID-19 vaccine development are the powerful antidote to the expensive valuation argument.

S&P 500 Forward P/E Ratio

Source: Bloomberg

Also, the market has already had the chance to digest the corporate earnings over the past month, and with over 90% of the S&P 500 member companies having now reported, there will be a void of fundamental data in the coming months for the market to react to. As I wrote in my last blog post, the management commentary from this earnings season was expected to be murky given the high degree of uncertainty the economic lockdown has introduced. However, there was a surprising amount of bullishness from some management teams. Here are just a few samples of the bullish tone from management of a few companies I own in the Leon Frazer U.S. Dividend Fund:

Mastercard: “I would tell you it feels like they’re beginning to enter into the early stages of what we had called normalization…what you’re seeing is that improving trend has sustained itself through the first 2 weeks of May…There seems to be a bigger bounce in the United States right now than there is in the rest of the world…you can see it in hotel bookings for weekends, it’s beginning.”

Nike: “Our strong digital footprint and capabilities are serving us well. We are seeing accelerated new member acquisition and strong digital demand across the global marketplace, with increased traffic and engagement on our mobile commerce and activity apps. We have increased our digital fulfillment capacity to meet this higher than anticipated demand which is partially offsetting declines in NIKE-owned stores.”

Procter & Gamble: “Just 2 days ago, we announced a 6% increase in our dividend, reflecting both these results and the confidence we have in our future. This was the 64th consecutive annual increase and the 130th consecutive year in which P&G has paid a dividend. So that’s January through March and fiscal year-to-date, very strong results in very difficult conditions.”

Much has been written about the underperformance of value stocks and the extreme performance divergence between growth and value stocks. This behaviour appears to contradict the optimism for a quick recovery in the economy that is currently being discounted by stocks. When growth stocks are providing market leadership and investors are shunning value stocks, this actually signals a pessimistic view of economic growth and corporate profits. Investors have bid up secular growth winners like the FAANG stocks partly because these companies can generate revenue growth irrespective of the economy’s health.

Normally, when investors have an optimistic view of economic growth, they will flock to value stocks that have discounted valuations and provide leverage to the economy. During this two-month period where U.S. stocks have rallied 30% in anticipation of a sharp economic recovery in the back half of 2020 and a rebound in corporate profits in 2021, the economically sensitive value stocks have significantly underperformed the growth stocks. This signals that investors do not believe in a V-shaped recovery for economic growth and corporate profits.

Growth vs Value

Source: Bloomberg

Looking at the performance by sector tells the same story. The U.S. Technology sector is the only sector with a positive return on a year-to-date basis. The Communication Services and Health Care sectors are only down marginally. Not surprisingly, these three sectors contain a cohort of growth companies that are either beneficiaries from the economic lockdown or are less affected by it. These sectors also comprise more than 50% of the S&P 500 index, which partly explains why U.S. stocks have dominated other regional stock markets in performance. The worst performing sectors are Energy, Financials and Industrials, which house many value stocks that are the most sensitive to the economy and suffering the most from the economic lockdown.

Source: Bloomberg

A change in leadership from growth to cyclical stocks like banks would not only send the right signals about the health of the consumer and the overall economy, it would also improve the market breadth and help push the market past any psychological or technical resistance levels. Until that happens, the short term direction of stocks is highly dependent on developments of a treatment or cure for COVID-19 with 3,000 acting as resistance to further upside in the S&P 500.

Lieh Wang, CIO
iA Investment Counsel