Market Update - August 2020

A little over five months after plunging -34% in the midst of a health crisis, U.S. equities managed to hit an all-time high in August. This comes as companies reported better-than-expected earnings results for the second quarter of the year, and a growing number of economic indicators (such as retail sales) continue to improve faster than expected.

It really has been a tale of two markets though – growth investments in technology and materials (gold) have seen advances of 30-50%+ on the year, while “safer” investments in banks, insurance companies and pipelines/utilities have yet to recover from severe losses. In fact, if it wasn’t for the biggest technology stocks in the US (Facebook, Amazon, Nvidia, Google, Microsoft Apple and Netflix - FANGMAN), the S&P 500 would still be negative on the year (chart below)!

It has been much the same in Canada. Technology stocks such as Shopify and materials stocks such as Barrick Gold have had a massive recovery (chart below), while the performance of other sectors year-to-date has been lackluster or poor.

The high level of volatility we have seen to start the month of September can be directly attributed to a sell-off in the technology sector – as many wary investors feel that the rise in prices was too much, too fast. Despite the nervousness though, we are still comfortable with the economy as a whole. First, all evidence suggests that we are in the early stages of a new business cycle (see retail sales rebound in chart below), a time when equity-market performance is strongest on average. Second, monetary conditions continue to favour equity markets (record low interest rates), perhaps even more so than ever before. Intuitively then, it seems that unless one (or both) of these two elements – an early pullback in the business cycle or rates rising faster than expected – are called into question, further record highs are to be expected in the coming months.

I have talked with many investors who struggle to rationalize how the stock market can make new highs when the world is clearly not on a solid footing. Unemployment has yet to fully recover (chart below), and many businesses are struggling to stay open. Clearly, the virus will be with us for some time, and the concern of another major economic shutdown (second wave) still looms.

While we expect it could take years for the job market to fully recover (as employers are uncertain about the future), this alone should not be a deterrent to stay away from equities. Consider it took over 4 years for employment to fully recover after the Global Financial Crisis (2010-2014 in chart above) - a period which saw the stock market increase 280%!!

And while the drop in the first quarter of the year had little in common with the previous bear market (Global Financial Crisis), the magnitude of the rebound was in fact very similar to what we saw in 2009 (chart below). If this market continues to follow the 2009 trend – we could expect growth to continue, albeit at a slower pace than we’ve recently experienced.

There is a palatable strength to the market that we have not seen in some time, and it seems to be driven more by low interest rates rather than by pure speculation. The chart below shows the Price-to Earnings ratio in blue and the Equity-Risk-Premium in red. The price-to-earnings ratio (PE ratio) measures how expensive the stock market is compared to how much companies are earning. Not surprisingly, this ratio has risen dramatically in recent months (the stock market has gone up, while earnings have been flat or in decline). The fact that the PE ratio is now approaching levels not seen since the 2000 tech crash has many investors concerned – however unlike in 2000, the equity-risk-premium is stable. The risk premium measures the return an equity investor receives for owning stocks over government bonds. That premium suggests that even at today’s elevated prices, equities are a good place to invest.

Volatility isn’t going away – and we expect to see more corrections like we have seen over the past few days. But as long as the economic recovery keeps moving in the right direction and interest rates remain low, the current upwards trend should continue.

As always, if you have any specific questions related to your individual portfolio, please feel free to reach out to myself or any of our other team members.

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