Eye on the Markets - 2020


A Tug of War between the Bears and the Bulls

By Ketu Desai

The market traded in a range in June, stuck in a tug of war between the bears and bulls. COVID-19 hot spots, trade tension, and economic uncertainty kept a lid on gains, while scientific progress, liquidity, and positive economic surprises provided a floor. The number of “shots on goal" from some the world's smartest scientists continues to increase. The World Health Organization says there are now 17 vaccine candidates in clinical evaluation and another 132 in pre-clinical evaluation. In addition, companies such as Eli Lilly, Regeneron and Merck are making progress on a treatment. Scientific progress helps the market get comfortable with out-year earnings, liquidity is the bridge. The Fed balance sheet has nearly doubled from a year ago, and is on its way to over $10 trillion, nearly 50 percent of GDP. Further, there are over $4 trillion of assets in money market accounts, according to the FDIC a record $2 trillion has hit deposit accounts since January, and there is approximately $1.5 trillion of private equity dry powder. With real yields dipping further into negative territory, this liquidity will need a new home. The S&P earnings yield is more than 6 percent greater than real yields, or in the 6th percentile of history. Market multiples are elevated relative to history, however, they usually are coming out of recession.

At risk of over-simplifying, the market is essentially trading underlying factors in three buckets, defensive, value/cyclical, and growth/secular winners. The defensive names include utilities, and certain consumer staples, telecom, and real estate related names. Many of these names are bond proxies, expensive, highly levered, low growth, and low margin companies. The barbell of defensive names with growth/secular winners in tech/healthcare was the portfolio to have for the past couple of years coming into COVID-19. The market is telling you that the barbell moving forward is tech/healthcare names with value/cyclical names. Tech and healthcare are the new defensive names. They have strong balance sheets, low leverage, high margins, low fixed costs, and high growth. As the economy recovers, value and cyclicals have the most upside while having the lowest valuations.

The recent economic data has positively surprised, supporting cyclical names. The Citigroup Economic Surprise Index hit its highest level over the past decade, by a wide margin. We have witnessed meaningful beats from a wide range of economic series ranging from payrolls, retail sales, regional manufacturing indices, consumer confidence, personal spending, durable goods orders, and PMIs. The recovery will be uneven; therefore, a more targeted approach in cyclical exposure has merit. One area to target is housing and home renovation. The housing data shows a meaningful recovery, new home sales are up 16.6 percent, pending home sales up 44 percent, and mortgage demand is at the highest in 11-years, home buying demand according to Redfin is up 25 percent, NAHB housing index jumped the highest on record, and permits are up 15 percent. Earnings and guidance from names such as Toll, Lennar, and Sherwin Williams confirm the recovery. Millennial family formation, low rates, work from home, and a potential secular shift away from dense populations could drive housing for years to come.

Signals from other assets classes further suggest that the economy has bottomed and a cyclical recovery is underway. The rally in commodities such as oil, copper, iron ore, aluminum, tin, lumber, and zinc point to a global manufacturing recovery. High-yield issuance in June was a record, up 71 percent YTD, and spreads are over 400 bps tighter since March. Investment grade issuance is also setting records, at a pace that is double that of last year. The dollar has broken previous support of the 50-day and 200-day moving average, which further supports the recovery, especially for multinationals. Markets can either correct with time or through price, the action in June suggests it was doing the former, resulting in range-bound trading. A range that ultimately sided with the bulls, there are simply too many powerful forces including science, the government, and the Fed on the bulls' side.

Looking forward, the market will focus on COVID-19, economic data, and second quarter earnings.

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Ketu Desai is the Principal of i-squared Wealth Management Inc. (www.isquaredwealth.com), an investment management firm based in New Jersey. ketu@isquaredwealth.com