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Volatility, Market Leadership and the Future

May 15, 2020
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We have suggested in recent weeks that the market and economic recovery will take time, that there will be  volatility along the way. The volatility of an investment is commonly expressed using a measure called  “standard deviation”. This is represented in finance by the lower-case Greek letter Sigma “σ”. Standard  deviation is the historical variation of the returns of an investment compared to its own mean, or average,  return. This necessarily includes not only the degree to which an investment falls below its average return but  also the extent to which performance exceeds the average. This is a more academic, but hopefully interesting  way to explain what we mean by volatility. There will be strong up days in the market, and there will be strong  down days. Last week the market had a few great days. This week the market has been terrible for a few days  in a row. Taken together, a spike in standard deviation (an increase in volatility) is the result.  

What follows is a more detailed explanation of the state of investment markets than we usually offer. Our  desire here is to provide professional education in a manner than is both interesting and understandable. We  are ever cognizant of the intellectual aptitude of our readership, as well as your desire for knowledge. The risk  is that you may find this to be either too technical, not at all interesting, or both. We hope this will not be the  case. Perhaps you will let us know. 

Stock Markets Now:

Today, Friday May 15th, marks the 37thday of the COVID-19 bear market. This has been one of the most  remarkable periods in capital market history. There is no parallel in terms of the speed of the decline, initial  recovery and policy response. We are now at an important juncture. Institutional investors may determine  that this is the start of a new bull market. They may conclude that recent gains are simply price rallies that can  be normal during a sustained downward-trending market. The eventual reality will depend upon the success  of newly opened state economies over time and the extent to which the COVID-19 crisis has caused  fundamental, structural changes to the way consumers and companies operate.  

It has been said that fundamental security analysis is a chalkboard full of math, information gleaned from the  balance sheets and income statements of publicly traded firms. The purpose of fundamental analysis is to  determine the value of a company today and to make estimates of its future value. It is the process of coming  to know a potential investment intimately, developing faith in its leadership, financial structure, earnings  potential, market position and strategic plans. The crisis response of the Federal Reserve, in terms of record  levels of easy money, has rendered this very detailed and intensive process temporarily unnecessary.  Optimism about the future overrides fundamentals in the present. Case in point: consensus earnings on the  S&P 500 for 2020 have come down from $175 at the start of the year to $127 as of last Friday. In other words,  the market believes that the aggregate earnings of all S&P 500 companies will be approximately 27% lower  than was assumed five months ago. At $127, the S&P 500 is currently trading at approximately 23 times  consensus 2020 earnings. The historical average is 16 times earnings. What does this mean?  

We sometimes refer to stocks as being “on sale”, “fairly priced” or “expensive”. On a one-year basis, the S&P  500 has only been more expensive than it is today 1% of the time. Of additional concern is that the index is  more concentrated now than at any point in the past 30 years, giving outsized influence to a relatively small  number of firms.  

The S&P 500 is a “cap-weighted” index. This means that the larger a company’s aggregate equity value (the  greater its capitalization), the larger its weighting within the index. Apple, Facebook, Amazon, Microsoft and  Google make up 20% of the S&P 500 index. The other 495 companies make up the remaining 80%. The strong  performance of these large firms in recent weeks has driven the market recovery and understates the impact  of the crisis on the market more broadly. If the S&P 500 were comprised of an equal weighting of all  companies, it would be roughly 24% below its all-time high in February. Based upon its current, cap-weighted  methodology, the S&P 500 is 16% below the February high.  

The top five firms in the S&P 500 share important characteristics. They have products and services with little  or no direct competition, access to capital at extremely low rates, above average profit margins, and high  forecasted revenue growth rates. A baseball analogy, if you don’t mind. These “big 5” firms remind us of Alex  Rodriguez in 2000. He was a five-tool player, had a bright future, and commanded a high salary. Yet, as the  Texas Rangers of 2001-2003 learned, one great player does not make a great baseball team. Capital markets  work the same way; a broad market rally is sustainable. A market rally that is narrowly concentrated in a  handful of successful companies is fragile.  

One way to validate the strength of a rally in one market, in this case, U.S. large company stocks, is to examine  other markets, both domestic and non-U.S. Unfortunately, we see relative weakness everywhere else. The  Russell 2000 Index, a measure of domestic small company stocks, is still down roughly 27% from its peak. The  MSCI EAFE (foreign developed market large company stocks) and the EAFE Small-Cap Index (foreign developed  market small company stocks) are both down roughly 20% from their peaks, as is the MSCI Emerging Markets  Index.  

We think it important to pause here and explain the implications of these recovery rates to investors who own  diversified portfolios (all of you, and us). This necessarily starts with an explanation of the finance concept of  “correlation”. Correlation is the extent to which a change in the price of one asset is reflected in a change in  the price of another asset. In normal circumstances, a diversified portfolio is comprised of various asset  classes that are not expected to change in price to the same degree, in the same direction, at the same time.  The result is that at any given moment, some investments will be doing well while others will be doing less  well. The best performing asset classes rotate over time and are unpredictable. Rarely, such as during the  2008-2009 period and again just recently, a crisis hits and correlations among most/ all asset classes goes to  one. Every asset falls at the same time and to relatively the same magnitude. After a “bottom” is reached and  recovery begins, divergence resumes, and different asset classes recover at different rates based upon a  variety of factors. More simply stated, investors’ willingness to hold risk assets across a range of market caps  and styles declined rapidly in March, producing a flood of selling. As markets stabilized, buying resumed. But  this buying activity is more discriminating and is focused most on the areas of the market deemed particularly  attractive given current economic conditions.  

This explains why the rate of recovery in your diversified portfolios will not be as steep as the drop in value you  experienced when the COVID-19 crisis hit. And it also explains our recent allocation shift to more actively  managed investments. The idea is to capture returns more selectively during the recovery period. 

Stock Markets Going Forward:

The preceding is not to suggest that we are on the cusp of another 34% downturn in the equity markets. The  swift transition of consumers and businesses to online services strengthens the market position of technology,  healthcare and communications firms. Those companies that can adapt to the new dynamic that COVID-19  brings to the economy are being handsomely rewarded, as they should be. The rest of the market will need  time to adjust their business models, time that in normal circumstances most companies can’t afford to take.  But these are not normal circumstances. The Federal Reserve’s easy money and asset purchase programs  lower the normal economic cost of necessary business model reengineering. In such a situation, the stretched  valuations we described above are less worrisome.  

With a fuller understanding of the broader economic context, the recent rally in domestic large company  stocks makes sense. Optimists are relying on the opening of state economies to ignite economic activity that  has been dormant, or at least considerably muted, for the past several weeks. If state economies can resume  economic activity with little negative public health consequences, we may see gains in other areas of the  equity markets, such as domestic small company stocks. Tempering return expectations are the increased  costs and lost efficiency that businesses will endure until the virus is under control. Gauging the impact of this  transition on corporate earnings is nearly impossible right now, as 40% of S&P 500 companies have suspended  earning guidance. Amazon reported that they would need to spend $4 billion on COVID-related expenses. We  simply do not know what the “other side” will look like. We do know that there are economic backstops in  place and some firms are more prepared than others. In summary, do not fear the rally in the face of  disappointing economic data, but remain cognizant that this is a process that will take time, and the road to  recovery may continue to be rocky.  

The Bond Market:

While the optimistic equity market was able to ignore last week’s extraordinarily bad jobs report, the U.S.  Treasury market was not. Short-term Treasuries are still offering record low yields, despite the highest levels  of supply from the US Treasury ever. At 0.14%, these are the types of securities investors buy when their  primary concern is the return of their money, not the yield on their money. Yields on longer-dated Treasuries  are either at or near all-time lows.  

Much like the equity market, there are areas of the bond market that have shown resilience. Investment  grade corporate bonds, with the explicit backing of the Fed, have recovered 100% of their COVID-19 losses and  are positive year to date. Agency mortgage-backed securities, with the backing of both the Federal Reserve  and U.S. Treasury, are up nearly 5% over the same period. High-yield bonds on the other hand, are still down  roughly 10%.  

While the index for investment grade bonds is positive, it is very interesting to note the implications of new  bond issues coming to market. Corporate America issued $285 billion of new investment grade bonds in April,  breaking March’s all-time monthly issuance record. Many companies have likely gained access to financing  simply on the strength of the Federal Reserve’s intentions to intervene in credit markets. Yet investment  grade bonds have rarely been cheaper on a relative basis. It is somewhat hard to believe that 2.5% is an  attractive yield, but remember, bonds are a relative game and the competition (U.S. Treasuries) is paying  0.14%. A normal spread, or additional yield relative to Treasuries, is 0.93%. Without going into the details of  spread duration, the total return for investment grade bonds may remain in the high-single digits for several  years as the economic conditions and credit markets normalize. The bond fund managers at TIAA, Schwab and  Fidelity have been actively adding exposure to investment grade credit over the past month.  

One area of the bond market that has received attention is the mortgage-backed security market. In March,  the White House suggested that homeowners would be able to suspend their mortgage payments during the 

crisis. Rather expectedly, this poor choice of words put extreme stress on the mortgage market. There is  simply no facility in place at the federal level to allow wide-spread mortgage forbearance. Securities backed by  monthly mortgage payments experienced losses that exceeded the financial crisis in a matter of two weeks.  The situation has since come under control due to additional programs from The U.S. Treasury and  unexpectedly low levels of missed mortgage payments thus far. Mortgages that are not backed by the US  government, referred to as non-agency, are still offering yields that are twice as high as they were pre-crisis.  


The equity market and bond market are both signaling that the worst-case scenarios projected in March are  unlikely to occur. This view is somewhat disconnected from current economic data and is based upon the  assumption that policy interventions from the U.S. Federal Reserve and U.S. Congress will propel the economy  into recovery at an accelerated rate. The Federal Reserve buying investment grade bonds, Treasury securities  and agency mortgage-backed securities serves essentially as risk mitigation, encouraging investor  participation. Low interest rates in the bond market also make equities more attractive.  

Much is unknown. We are experiencing a social experiment intended to safeguard public health, which  appears to be working. Policy makers now face the difficult task of balancing competing priorities. The  loudest voices on both sides should perhaps be ignored. The success of the next phase will depend, in our  view, largely on the confidence level of the consumer, in two ways. If/ when the public feels secure that they  may resume physical social and professional interactions without risk and feels secure that they may resume  normal spending levels, then we will be more completely on the road to economic recovery. Meeting both  criteria is going to take longer than the optimists desire but hopefully not as long as the more cautious assume.  

We have communicated a great deal of information this week. We hope that this has been interesting and not  overwhelming. If you have questions or comments, please let us know. In the meantime, our sincere best  wishes to you, your family and friends for continued health and happiness.  

Personal Investment Management, Inc. 

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