Choppiness in early September due to the alarming rise in the number of U.S. Covid-19 cases has given way to 4th quarter optimism as investors digest this latest news cycle. The U.S. has just surpassed over 13 million cases since January and continues to add over 150,000 cases per day, a number that will unfortunately continue to grow as the weather gets colder and people gather for the holiday season. Fear of another shutdown and failure to approve a second stimulus package helped fuel a more than 9% decline in the broad U.S. market, as measured by Russell 3000, from September 2nd to the 23rd. Most recently, fears of a blue wave and contested election results weighed on returns as volatility spiked and the broad market, declined more than 7% from mid to late October. However, since November the market has rallied to new highs while the volatility index has fallen over 40% in that same time period. Interestingly, over the last three months there has been some divergence from long-term market trends that are worth watching as the year comes to an end and investors focus on the future. While there is a strong basis for optimism many catalysts remain that could lead to continued volatility and the need for investor caution.
After the election, the market began to rebound as worries of a blue wave and a contested election abated. While the market was expecting Joe Biden to win the presidency, there was a fear that the Senate would flip from a Republican to Democratic majority, with Democrats also retaining control of the House. Currently, Democrats have control of the House while Republicans hold a two-seat lead in the Senate. Last week the President began the formal transition to the President-elect allowing the new administration access to federal agencies and intelligence briefs. Importantly, the Biden administration has nominated Janet Yellen, the former Federal Reserve chairwomen, to be Treasury secretary at a time when the economic recovery in the U.S. is beginning to slow and a second stimulus bill has failed to find bipartisan support.
Attention now shifts to Georgia where there are still two seats open set to be filled by two early January runoff elections. As of now the market seems to be pricing in the most likely scenario which is that at least one of the incumbent Republicans wins resulting in gridlock and neither side being able to push through sweeping reforms. If both Democratic challengers were to win, Kamala Harris as president of the Senate would be the tie-breaking vote leading to a higher likelihood of policy changes such as higher corporate and personal taxes. Investors should expect continued volatility through the New Year as the political landscape continues to shakeout.
Much of the upward momentum of the market is being fueled by new positive news on the vaccine front. Pfizer and a German biotechnology company, BioNTech, were the first to release preliminary results that their vaccine was 95% effective against COVID-19. Moderna quickly followed with initial results of a vaccine efficacy of 94.5% followed by further analysis finding the vaccine 94.1% effective and announced plans to request clearance from U.S. and European regulators. AstraZeneca also found that its vaccine on average was 70% effective against COVID-19, with efficacy ranging from 62% to 90% depending on the dosage.
Based on this positive news we have seen the major indexes hit all-time highs. With all of this optimism, valuations are beginning to look stretched in certain areas. The forward P/E for the S&P 500 is 21.8x compared to its 25-year average of 16.53x. This comes at a time, however, of historically low interest rates. The 10-year Treasury is yielding 0.92%, implying negative real yields when factoring in inflation.
One of the more interesting dynamics unfolding over the last 3 months has been the outperformance of small cap and value equities versus large cap growth equities which have been outperforming for most of the last decade.
Breaking down the sector exposure between large cap and small cap equities we can begin to evaluate what has been driving the recent performance.
Both the Russell 2000 and value indexes have large weightings in financials which rallied after positive vaccine news caused the yield curve to steepen. Banks generally make money by lending money at longer term rates and borrowing money at shorter term rates. After having largely underperformed because of airlines and defense industries the industrial sector is also helping drive recent gains. Industrial production and manufacturing have been strong. The most recent Manufacturing PMI was 57.5% indicating expansion in the overall economy for the seventh month in a row. The New Orders Index registered 65.1%, slightly off the 67.9% reported in October which was the highest reading since 2004. The Customers’ Inventories Index was at 36.3% its lowest figure in a decade and a level considered a positive for future production.3 In addition to renewed optimism about the possibility of future travel, a divided government bodes well for an infrastructure bill, which is one of the few things that usually garners bipartisan support. Generally, cyclical sectors which are often more heavily weighted in small cap and value equities perform well coming out of recessionary periods and the outlook for future earnings growth becomes more positive. While the long-term trends and tailwinds are still in place for large cap growth and technology it’s an interesting market development worth watching.
With all this news, it is important that investors remain vigilant and not throw caution to the wind. Even with the positive news, a vaccine will not be widely distributed for months and with the continued increase in coronavirus cases across the country, new state and local restrictions meant to curb the spread and voluntary social avoidance could create earnings weakness and GDP declines that could spur more volatility in the short term. In addition, there are still questions surrounding the emergency lending facilities set to expire at the end of this year and as to when a second stimulus bill will be approved and what it will look like. Over the longer-term investors need to grapple with things like the rise in national debt which currently sits at about 100% of GDP, extended market valuations, negative real yields, and deteriorating demographics. Regardless of the market environment, investors should review their allocation and any new life events with their advisor and continue to remain focused on their long-term goals and objectives.
1 Morningstar, Charles Schwab
2 J.P. Morgan Asset Management
3 November 2020 Manufacturing ISM® Report On Business®