Jul 29, 2020 2020 Second Quarter Commentary

Market Summary

The second quarter was nearly a mirror image of the first, as investors’ appetite for safety in the first quarter turned into an appetite for risk in the second quarter. The first quarter saw the fastest ever bear market – down 34% in 20 trading days – before recovering to finish down 20% for the first quarter. In the second quarter, S&P 500 staged its best 50-day rally ever[1]. The sharp snapback led to a 20% second-quarter gain and brought the S&P 500 to within 3% of a positive year[2]. (Note that a 20% decline requires a 25% gain to get back to even). All sectors, regions, and countries posted positive returns.

Increased optimism regarding the pace and shape of the economic recovery and the easing of COVID-19 lockdowns allowed most businesses to reopen in some capacity drove the sharp rebound in asset prices. The quick recovery was also partially attributable to the massive policy responses from both government stimulus and central banks around the world to help the economic recovery and provide ample liquidity. By quarter’s end, some of the optimism waned as COVID-19 cases flared up in states that had avoided the initial round of cases, and some policy measures to expire at the end of August.

The recent trends in equity markets have been amplified year to date. Namely, US growth stocks continued their run of outperformance over most other styles and strategies. For example, US value stocks, as measured using French and Fama data, were in their longest and second sharpest relative drawdown since 1933[3]. Furthermore, US stocks continued their recent trend of outperforming non-US stocks. International stocks remained attractively valued on a relative basis: the MSCI EAFE traded at 17.1 times forward earnings versus 24.2 times for the S&P 500 Index[4]. Finally, small-cap stocks broke their recent trend of underperformance relative to large caps and outperformed during the quarter.

In the bond markets, the second quarter was also a mirror image of the flight-to-safety trend that dominated the first quarter. Riskier corners of the bond market fared the best, led by high-yield bonds and emerging-markets debt, while safer government bonds were flat during the quarter. Below is a summary of returns for the quarter[5].

Road to Recovery Playbook

We continued to follow our Road to Recovery Playbook for guidance in assessing the market during the second quarter.

1. New COVID-19 cases in the United States

The path of the economy and markets in the second half of 2020 may depend on how much progress we make against COVID-19. Today much more is understood about the disease, including how it’s transmitted, its severity, and better treatment methods. While cases continued to grow, it appeared less dire than many of the most feared estimates in March.

Unfortunately, the situation is not universally positive. Data toward the end of the quarter showed new COVID-19 cases and hospitalizations were increasing. Deaths, however, continued to trend lower. (As of July 10th, deaths have begun to rise as well). Many of the earliest, hardest-hit states saw a consistent drop in cases and deaths, while increases in states spared from the initial wave offset the good news. Emerging reports about a vaccine are encouraging, but no one can say how successful they will be or when they will arrive.

2. The probability and severity of a recession

As a result of the lockdowns and business closures to contain COVID-19, the US economy (and much of the world’s economies) entered a recession in March 2020 per the National Bureau of Economic Research. GDP contracted by 5% during the first quarter of 2020 on an annualized basis. Bloomberg consensus expectations for the second quarter were calling for a historic 34.5% contraction on an annualized basis[7], likely making it the deepest US economic contraction on record. However, the current expectation is for the recession to be short-lived, with recovery starting in the third quarter.

 

Most of the data reflect a consistent story: a sharp and sudden decline in economic activity, spending, and household income during the implementation of the shutdown. We’re now seeing a quick turnaround in most measures. However, we remained well below pre-shutdown levels of activity as policymakers and health officials continued to try to walk the line between health consequences and economic recovery.

3. Markets priced in a recession and are now pricing in an economic recovery

Many investors are wondering, with the economy performing so poorly, why has the stock market recovered so dramatically? On the one hand, gains may appear appropriate based on the possibility that the recession may be short-lived, aided by the massive stimulus response by policymakers. On the other hand, the risk of a second wave of COVID-19 remains, particularly as some southern and western states see increases in infections and hospitalizations. Also, some of the 20 million jobs lost may take a while to come back due to social-distancing constraints and the potential for lasting changes in consumer behavior.

Predicting the duration and severity of any decline is impossible, especially a fall with the magnitude and speed of this shock. We know the stock market is forward-looking: It focuses on what’s happening today and what it sees on the path ahead. Much of the real-time economic data —such as transportation activity, home sales, and jobless claims—show tangible evidence that economic activity—while still depressed—began to make a comeback. We expect improving economic data and earnings in the second half of the year, although uncertainty remained high with the US election, continued trade disputes, and how COVID-19 will spread.

In the US, a relatively small number of successful technology companies have achieved enormous market capitalizations, giving them the ability to influence the returns of the market-cap-weighted indexes, such as the S&P 500. In fact, the top five companies accounted for nearly 23% of the S&P 500, the highest concentration since 1990[8].

The dominance of these mega-cap growth stocks helps explain many of the recent trends in the market, specifically the underperformance of value strategies, smaller companies, and non-U.S. equities. Looking at historical valuations, we saw that value was around its long-term average while growth has gone up and up. For example, 33 percentage points separate the performance of the Morningstar US Growth Index from that of the Morningstar US Value Index. The sheer magnitude of this year’s divergence is such that, if the year finished this way, it would be growth’s most significant margin of outperformance since 1999[9].

Investors should remember that strategies go through cycles. The experts proclaimed the demise of the value factor in the late 1990s with the creation of the “New Economy.” Then after the bubble burst, value trounced growth for years. Value suffered far less than growth in the early 2000s bear market, it outpaced growth during the rally of 2003-07, and it lost less in 2008. At quarter-end, many stocks in the value, international and small-cap space were still priced at recessionary levels and may have upside potential if the economy continues its recovery.

4. Sentiment and technical analysis indicate a potential for continued stock market gains

From a technical perspective, the sharp decline and subsequent sharp reversal gave us evidence that the market bottom may have occurred in March, and an early-cycle recovery may have started in the second quarter. Many signs of a bear market bottom signaled in the first quarter, including depressed investor sentiment, extremely oversold conditions, widening credit spreads, and policy response to the systemic shock. In the second quarter, we saw signs of recovery including:

  • Investor sentiment increased from extremely pessimistic in the first quarter to more neutral levels in the second quarter, but the sentiment was not overly optimistic.
  • Corporate credit spreads narrowed substantially during the second quarter.
  • The combination of substantial price gains and strong breadth coming off a significant decline as we saw in the first quarter has historically been a positive sign for continued stock market strength.

While some investors may be tempted to abandon equities and go to cash, a point to keep in mind is that equities historically bottom 3-6 months before a recession ends. Given the anticipation for economic recovery in the third quarter, equity markets may have already bottomed.

For example, across the two years that follow a recession’s onset, equities have a history of positive performance. Data covering the past century’s 15 US recessions show that sticking with stocks has reward investors. The graph below shows that in 11 of the 15 instances, or 73% of the time, returns on stocks were positive two years after a recession began[10]. The annualized market return for the two years following a recession’s start averaged 7.8%. Historical performance can’t predict future returns.

5. Will policymakers’ response be enough to restore confidence?  

We had the “shock and awe” policy response from governments and central banks worldwide to help cushion the economic decline. The below chart shows the amount of stimulus from both Central Banks and lawmakers as a percentage of Gross Domestic Product (GDP)[11]. These measures are much larger than during the 2008-2009 global financial crisis. While there are limits to what governments can do to sustain the recovery, we expect the stimulus to persist well into the next cycle, helping support risky assets.

We’re mindful that it’s been an extremely challenging year so far in the US and around the globe. We’re in a pandemic that continues to impact all of us, our communities, and our economies. There is still significant uncertainty that may lead to more market volatility. Nevertheless, we encourage focus on the long term.

Please reach out to your advisor if you have any questions or concerns.

 

IMPORTANT DISCLOSURES

Leonard Rickey Investment Advisors, PLLC (“LRIA”), is an SEC registered investment adviser located in the State of Washington. Registration does not imply a certain level of skill or training. For information pertaining to the registration status of LRIA, please contact LRIA or refer to the Investment Adviser Public Disclosure website (www.adviserinfo.sec.gov).

 

This newsletter is provided for general information only and contains information that is not suitable for everyone. As such, nothing herein should be construed as the provision of specific investment advice or recommendations for any individual.  To determine which investments may be appropriate for you, consult your financial advisor prior to investing. All performance referenced herein is historical in nature and is not an indication of or a guarantee of future results. All indices are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment.

 

Your experience may vary according to your individual circumstances and there can be no assurance that LRIA will be able to achieve similar results for all clients in comparable situations or that any strategy or investment will prove profitable.   As investment returns, inflation, taxes and other economic conditions vary, your actual results may vary significantly. The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful. There is no guarantee that the views and opinions expressed herein will come to pass. This newsletter contains information derived from third party sources. Although we believe these third-party sources to be reliable, we make no representations as to the accuracy or completeness of any information prepared by any unaffiliated third party incorporated herein, and take no responsibility, therefore.

 

Stock investing includes numerous specific risks including the fluctuations of dividend, loss of principal, and potential illiquidity of the investment in a falling market. International and emerging markets investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. Small cap stocks may be subject to a higher degree of risk than more established companies’ securities. The illiquidity of the small cap market may adversely affect the value of these investments. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. This newsletter should not be regarded as a complete analysis of the subjects discussed. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise and bonds are subject to availability and change in price. The risks associated with investment-grade corporate bonds are considered significantly higher than those associated with first-class government bonds. The difference between rates for first-class government bonds and investment-grade bonds is called investment-grade spread. The range of this spread is an indicator of the market’s belief in the stability of the economy. The fast price swings in commodities and currencies can result in significant volatility in an investor’s holdings. There is no assurance that the techniques and strategies discussed are suitable for all investors or will yield positive outcomes. The Value investments can perform differently from the market as a whole. They can remain undervalued by the market for long periods of time.

 

Any projections, forecasts and estimates, including without limitation any statement using “expect” or “believe” or any variation of either term or a similar term, contained here are forward-looking statements and are based upon certain current assumptions, beliefs and expectations that LRIA considers reasonable or that the applicable third parties have identified as such. Forward-looking statements are necessarily speculative in nature, and it can be expected that some or all the assumptions or beliefs underlying the forward-looking statements will not materialize or will vary significantly from actual results or outcomes. Some important factors that could cause actual results or outcomes to differ materially from those in any forward-looking statements include, among others, changes in interest rates and general economic conditions in the US and globally, changes in the liquidity available in the market, change and volatility in the value of the US dollar, market volatility and distressed credit markets, and other market, financial or legal uncertainties. Consequently, the inclusion of forward-looking statements herein should not be regarded as a representation by LRIA or any other person or entity of the outcomes or results that will be achieved by following any recommendations contained herein. While the forward-looking statements here reflect estimates, expectations and beliefs, they are not guarantees of future performance or outcomes. LRIA has no obligation to update or otherwise revise any forward-looking statements, including any revisions to reflect changes in economic conditions or other circumstances arising after the date hereof or to reflect the occurrence of events (whether anticipated or unanticipated), even if the underlying assumptions do not come to fruition. Opinions expressed herein are subject to change without notice and do not necessarily consider the particular investment objectives, financial situations, or particular needs of all investors. For additional information about LRIA, including fees and services, please contact us for our Form ADV disclosure brochure using our contact information herein. Please read the disclosure brochure carefully before you invest or send money.

 

INDEX DEFINITIONS

The Barclays Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the US investment-grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.

The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. It cannot be invested into directly.

The Russell 2000 Index is an unmanaged index generally representative of the 2,000 smallest companies in the Russell Index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index.

The MSCI Emerging Markets Index is a float-adjusted market capitalization index that consists of indices of approximately 800 stocks and is designed to measure equity market performance in 23 emerging economies: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, , Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey, and the United Arab Emirates.

The MSCI EAFE (Europe, Australasia, Far East) Index is a free float-adjusted market capitalization index of approximately 900 stocks and is designed to measure equity market performance in 21 developed market countries outside of North America.

The SG Trend Index is a subset of the SG CTA Index, and follows traders of trend following methodologies. The SG CTA Index is equal weighted, calculates the daily rate of return for a pool of CTAs selected from the larger managers that are open to new investment.

Swiss Re Global Cat Bond Index tracks the aggregate performance of all catastrophe bonds issued offered under Rule 144A. The index captures bonds denominated in any currency, all rated and unrated cat bonds, outstanding perils, and triggers. The index is not exposed to currency risk from non-USD denominated cat bonds.

Morningstar US Growth Index tracks the performance of stocks that are expected to grow at a faster pace than the rest of the market as measured by forward earnings, historical earnings, book value, cash flow and sales.

Morningstar US Value Index tracks the performance of stocks with relatively low prices given anticipated per-share earnings, book value, cash flow, sales and dividends.

[1] LPL Research

[2] As of June 30, 2020

[3] Kenneth R. French Data Library

[4] Dodge & Cox

[5] Morningstar Direct as of 6/30/2020.

[6] Alternatives benchmark includes 60% SG Trend Index and 40% Swiss Re Global Cat Bond TR Index.

[7] Source: LPL Research, Bloomberg 6/30/20

[8] Source: BofA Global Investment Strategy, Bloomberg

[9] Morningstar Research

[10] Dimensional Fund Advisors

[11] T Rowe Price Group

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Important Disclosures

Leonard Rickey Investment Advisors, PLLC (“LRIA”), is an SEC registered investment adviser located in the State of Washington. Registration does not imply a certain level of skill or training. For information pertaining to the registration status of LRIA, please contact LRIA or refer to the Investment Adviser Public Disclosure website (www.adviserinfo.sec.gov).

This is provided for general information only and contains information that is not suitable for everyone. As such, nothing herein should be construed as the provision of specific investment advice or recommendations for any individual. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. There is no guarantee that the views and opinions expressed herein will come to pass. This newsletter contains information derived from third party sources. Although we believe these third-party sources to be reliable, we make no representations as to the accuracy or completeness of any information prepared by any unaffiliated third party incorporated herein and take no responsibility therefore.

Any projections, forecasts and estimates, including without limitation any statement using “expect” or “believe” or any variation of either term or a similar term, contained here are forward-looking statements and are based upon certain current assumptions, beliefs and expectations that LRIA considers reasonable or that the applicable third parties have identified as such. Forward-looking statements are necessarily speculative in nature, and it can be expected that some or all of the assumptions or beliefs underlying the forward-looking statements will not materialize or will vary significantly from actual results or outcomes. Some important factors that could cause actual results or outcomes to differ materially from those in any forward-looking statements include, among others, changes in interest rates and general economic conditions in the U.S. and globally, changes in the liquidity available in the market, change and volatility in the value of the U.S. dollar, market volatility and distressed credit markets, and other market, financial or legal uncertainties. Consequently, the inclusion of forward-looking statements herein should not be regarded as a representation by LRIA or any other person or entity of the outcomes or results that will be achieved by following any recommendations contained herein. While the forward-looking statements here reflect estimates, expectations and beliefs, they are not guarantees of future performance or outcomes. LRIA has no obligation to update or otherwise revise any forward-looking statements, including any revisions to reflect changes in economic conditions or other circumstances arising after the date hereof or to reflect the occurrence of events (whether anticipated or unanticipated), even if the underlying assumptions do not come to fruition. Opinions expressed herein are subject to change without notice and do not necessarily take into account the particular investment objectives, financial situations, or particular needs of all investors.

For additional information about LRIA, including fees and services, please contact us for our Form ADV disclosure brochure using our contact information herein. Please read the disclosure brochure carefully before you invest or send money.