Less Bad: What Are Equities Telling Us?

04.24.2020 - Ronald J. Sanchez, CFA

Key Takeaways:
  • We believe investors should adopt a cautious and patient stance during a near-term market likely to be bumpy and winding with a downside bias.
  • We remain underweight global equities in favor of cash and favor US large-caps relative to international stocks.
  • Our preference is for countries, markets and companies that were the strongest prior to the coronavirus crisis with the expectation that they will best positioned to emerge in a post-virus world.

There is an old Irish story that tells of a city visitor, driving in the distant countryside and realizing he is hopelessly lost. Upon seeing a farmer along the roadside, the driver quickly pulled over and asked for directions back to Dublin. The village local, without missing a beat, said to the stranger, “Well, if I was you, I wouldn’t start from here.” Similar to that lost motorist, investors may feel as though they don’t know where equity markets are heading, however, we think it may be helpful to understand where equities have been to better gauge where they might go.

Our analysis to gain more insight led us to more closely examine the price movements of the S&P 500 Index (see nearby chart). We think that in order to navigate this unusual and unprecedented time in which there has been a near vacuum of meaningful economic and corporate fundamental data, it is informative to identify the drivers of today’s equity markets.  To this end, we have deconstructed the Index’s recent price history into five stages based on market developments.

The S&P 500 Narrative: Five Stages of Equity Price Levels

S&P 500 Index (January 1, 2020 through March 31, 2020)

Source: Bloomberg, as of 4/20/20.

First Stage: Nirvana

Simply put, in early 2020, the US economy was experiencing the perfect conditions for investors, with high conviction surrounding the stability, durability and visibility of the economy, corporate earnings and monetary policy. This seemingly perfect backdrop of low inflation, low and stable interest rates, and depressed market volatility, which all served as key underpinnings for investors placing premiums on risk assets. This nirvana-like dynamic dramatically changed in late February when a violent and swift downturn in equities occurred as the coronavirus crisis began to rage throughout financial markets.

Second Stage: Growing Shocks

As the crisis unfolded, the first negative fallout to impact financial markets was a supply shock as the shutdown in China hit supply chains around the world. With European countries, and then the US soon afterwards, shuttering their economies in an attempt to contain the spread, (i.e., “flatten the curve”), many parts of the US. economy essentially shut down, adding to the collapse in demand and economic activity. In the midst of this turmoil, Saudi Arabia and Russia engaged in an oil price war, sending the commodity into a tailspin which added to the negative market sentiment. As a result, the S&P 500, for the first time in over a decade, entered into bear market territory.

Third Stage: Unprecedented Crisis

As events continued to deteriorate at a lightning pace, the increasing prospects that the situation could spiral out of concern grew, including the threat that the healthcare system could be overwhelmed and economic chaos might seize up financial markets. The unprecedented crisis included mass liquidations, panic and a liquidity squeeze. This disorderly market built in a negative feedback loop as each headline pulled the market further down, with extreme outcomes being considered and many investors selling what they could as opposed to what they wanted. Markets appeared to be in a freefall as the S&P 500 fell sharply, declining another 17% over the course of two weeks to nearly 2,200.

Fourth Stage: Unprecedented Government Response

Give the unparalleled stress on the economy, markets, businesses, municipalities and individuals, federal policy makers have provided a one-two punch, equally unprecedented in scale and speed of delivery. The Federal Reserve has taken decisive action to ensure financial markets are functioning properly, liquidity is available, and credit is supported. Congress, in turn, has passed four fiscal packages to offset the ongoing economic disruption and help bridge the gap to when the economy can be reopened. The combined government support, based on a “whatever it takes” approach, could total approximately 35% of GDP. Based on these mitigation efforts, markets have bounced hard off their recent low levels as investors have gained confidence that the US government has stopped the downward spiral, mitigated the worst possible outcome and restored a functioning market.

Fifth Stage: Economic and Corporate Fundamentals

The big question facing investors now is where do we go from here? Following the strong, one-way move to the upside, we believe the road ahead is going to be quite challenging, bumpy and winding. Our team thinks that the bottom “V” in equity market price levels, shown in the chart, reflects a sentiment-driven relief rally based on the unprecedented federal government policy response and, perhaps, selling exhaustion. We do not expect the price action to be similar with respect to time, magnitude or direction. We believe we are entering a stage of the recovery that will ultimately be driven by economic and corporate fundamentals, with early evidence of the virus’ impact on the economy and corporate earnings (though with much still in the dark). Undoubtedly, economic and earnings data over upcoming months will be depression-like.

Our expectations are that, in the short term, economic uncertainty and stress remain high, presenting a challenging environment in which markets trade sideways and choppy, with a potential downside bias. Therefore, we believe it’s prudent to remain cautious and patient as we assess the wider impact of the virus on the economy and corporate earnings. We remain underweight global equities in favor of cash and favor US large caps relative to international stocks. Our preference is for countries, markets and companies that were the strongest prior to the coronavirus crisis with the expectation that they will be best positioned to emerge in a post-virus world. 

The information provided is intended solely to provide general information. The information and opinions stated may change without notice. The information and opinions do not represent a complete analysis of every material fact regarding any market, industry, sector or security. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy, or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.


The Shape of Recovery: Will Animal Spirits Reawaken?

05.06.2020 Viraj B. Patel, CFA, FRM, CAIA

The Shape of Recovery: Will Animal Spirits Reawaken?NEXT POST


The Road to Recovery from Alphabet City

04.15.2020 Douglas Cohen

The Road to Recovery from Alphabet CityPREVIOUS POST