Batten Down The Hatches
From the market's last high on February 19th through the latest closing bell on June 12th, the S&P 500 Index has produced a total return (price change plus dividends received) of -9.57%:
At first glance, the paltry drop to-date hardly seems adequate to account for the substantial uncertainty that the economy is still facing. Price gains notwithstanding, several factors point to a deterioration of the fundamentals. Although the Federal Reserve did reaffirm its commitment to financial support, it simultaneously issued pessimistic guidance on the economy. Furthermore, as quarantines have lifted, the virus is once again multiplying. To top it all off, political partisanship is beginning to reassert itself. Overall, the perceived likelihood of a U-shaped recovery has increased, and although many companies will successfully navigate these troubled waters, many will not. Investors should be prepared for a wider distribution of returns between companies, industries, and sectors.
So what gives?
As everyone knows, stocks are "forward-pricing", which means that their current price is a reflection of aggregate expectations about the future. Specifically, price reflects expectations about future earnings. If one looks to the constituent sectors of the S&P 500 Index, one begins to see why the market has on balance held up so well:
On February 18th, immediately prior to the latest market high, the Information Technology and Health Care sectors accounted for roughly 38% of the S&P 500 Index. Let's take a look at their estimated earnings per share:
As you can see, the estimated earnings per share for the top two sectors has declined by approximately 9% since the market's high, which just so happens to be the amount by which the index price level has fallen. Coincidence?......I think not.
When we expand the time horizon of the chart a little and add in the other sectors, it becomes apparent that the effects of coronavirus are not exerting themselves equally across the economic landscape. I have highlighted two additional sectors that have displayed resilience in their earnings estimates: Consumer Staples and Utilities.
It's important to keep in mind that the S&P 500 is a market-cap-weighted index. If something becomes larger in market cap, it contributes more to the index going forward. As companies in certain sectors (like Energy) have fallen in value by large amounts, companies in other sectors (like Information Technology) have fallen by much less. This has the effect of causing those companies to gain in their weightings in the index, which shifts the sectoral breakdown of the index and the sectoral composition of future earnings. With more of the index being "fed" by sectors with relatively strong EPS estimates, the index is achieving more "lift" than it otherwise could. In other words, the index is designed to shift itself over time towards the constituent companies that the market values most highly.
After the first initial bout of volatility and price declines, the market started recovering in March. Last week, though, the market encountered another bout of price changes that does not bode well for the immediate future:
In a previous post, I hypothesized that we had entered the "eye of the storm". I believe it is highly likely that we are now encountering the second storm wall. Several assets are indicating that this is a pronounced risk-off movement. The price action this week should, in my humble opinion, confirm whether or not that is the case. As of the posting of this blog, futures are down.
I believe it's time to batten down the hatches. It may or may not be too late to acquire efficient active hedges. An overallocation to cash is a relatively risk-averse way to mitigate volatility. Consider your options with the aid of a qualified financial advisor.