Stock markets have been on an uncomfortable ride in 2020, leaving open a great deal of confusion and many questions as to what happened and what comes next. While we don’t know with any certainty what comes next, we are beginning to understand what happened and why markets have responded so strongly since March 23rd.
This year has once again reminded us that stock market volatility is a basic axiom of investing. Although it may disappear for long stretches and the collective of investors are lulled into a sense of boredom, volatility inevitably returns at an unexpected time and in an unexpected way. What was different about this sell-off was the speed and severity with which volatility emerged. Since 1900, the Dow Jones Industrial Average (DJIA) has logged more than 30,000 trading days and we just experienced 3 of the best days ever, as well as 3 of the worst days ever.
We doubt a recap of events is necessary, as everyone’s current quarantined existence has made it difficult to avoid the market headlines, but in the graphic below you can see how quickly things changed. From the most recent all-time high on February 19th, the S&P 500 Index found itself in a more than 30% drawdown only 1 month later.
But on March 23rd the market abruptly stopped going down and began a relatively quick rebound. The market has not yet reclaimed its prior all-time highs, but with the S&P 500 crossing 3,000 and the DJIA advancing past 25,000, it is beginning to feel like a question of “when” not “if”.
The stock market tends to trade on two things – liquidity in the short-term and fundamentals in the long-term. If liquidity is ample it can be supportive for asset prices, but when liquidity is in decline asset prices can struggle to find a buyer.
When it became apparent the Federal Reserve and Congress were ready to funnel enormous amounts of money towards financial markets and the economy, sentiment shifted rapidly. The Fed played a stabilizing role in financial markets while Congress moved similarly to provide support to individuals, small businesses, municipalities, and nearly every other segment of the economy impacted by Coronavirus.
Central bankers and politicians were an important piece of the liquidity equation, but another element began to play an important role as well – corporate earnings. Over longer time frames, liquidity plays a secondary role to earnings.
What Do Earnings Say?
During the middle of March, stocks were being sold without a tremendous amount of distinction between companies that may potentially emerge from the recession in stronger position and those that might struggle to survive. Technology stocks, as one example, were down almost 30% from their peak despite many companies within that sector arguably seeing increased demand for their products.
If we look at tech earnings, the expectation entering this year was that the sector would experience 10% earnings growth in 2020. By May 31st, the expectation was for 1% growth this year. Lower, yes, but not dramatically so. A similar phenomenon has occurred in healthcare, utilities, and consumer staples sectors.
The same can’t be said for energy, consumer discretionary, industrials, and financials. Economically sensitive sectors like these are dealing with a slowdown in demand and a commensurate reassessment of earnings prospects. Despite the deceleration in demand, however, the relative importance of those sectors has diminished over time. Tech and healthcare alone are more than 40% of the S&P 500, whereas the previously mentioned economically sensitive sectors (energy, financials, consumer discretionary, and industrials) are collectively 30% of the index.
We do not highlight these discrepancies to place one or two sectors at a higher level of importance, but rather to suggest that stock markets today are uniquely positioned with diverse representation of companies and industries.
These Times Offer A Handful of Reminders
Market performance this year is a reminder why we must constantly think about the adage “time in the market is more important than timing the market.” Miss a few good days and your overall return experience is dramatically reduced. The same can be said of missing the worst days – if you have the skill or good luck of avoiding the 5 or 10 worst days in the market, you can increase your portfolio returns. The difficulty resides in the fact that the best and worst days are oftentimes clustered close together. Without an ability to know the future, it is very unlikely an investor can miss the worst days and only invest during the best of times.
The outlook for the economy and corporate earnings felt heavily tilted to the downside in March, but it is important to remember in those times that the market does not always trade on current conditions. Over short periods of time, liquidity can supersede all else. The Fed and Congress ensured that liquidity would be plentiful during this time of need, and markets responded positively. With the passage of time, liquidity gives way to fundamentals. This is where things become less clear. Earnings will assuredly contract this year, but there will be beneficiaries from increased adoption of work from home trends. At the same time, many segments of corporate America have yet to figure out what lies ahead.
This also speaks to why we take a balanced approach to investing in equity markets. A portfolio that includes growth and value stocks allows investors to participate in sectors like healthcare and tech that have held up relatively better this year while also recognizing that the past does not dictate the future. Markets trends can change quickly for a myriad of reasons. Just one example is that as we look at various firms’ return expectations over the next 10-, 20-, 30-years, the broad expectation is that value stocks will outperform growth. We cannot say with a high amount of certainty if this will happen, but we know that an approach that is diversified offers the opportunity to participate in the good stocks without overemphasizing the bad ones.