It’s like déjà vu all over again.
- Yogi Berra
Yogi Berra was known as much for his “Yogi-isms” as he was for his hall of fame baseball career. Like his coach, Casey Stengel and his “Stengelese”, he had a knack for unintentional witticisms and a unique and humorous way of crafting the English language leaving many befuddled. However, sometimes those malapropisms actually added to the sentiment in a way that accuracy of speaking might not have otherwise captured.
Halfway through the year, the world feels defined by struggle and contradiction. While we have watched Northeastern states begin to emerge from their battle against COVID-19, many of the Sun Belt states have seen a reversal of fortunes. On a global scale, new cases continue to set all-time records, while places hit hardest cautiously try to return to normal. Even our national pastime, which should be celebrating its halfway point with the All-Star Game, is still struggling just to get the season started. However, Mr. Market spent the second quarter acting as if all was right in the world, and the best was yet to come.
You can observe a lot by just watching.
- Yogi Berra
Despite the uncertainty, the Second Quarter was the best quarter for the S&P 500 since 1998, increasing by 20.5%. For the Dow Jones Industrial Average, it was the best quarter since 1987, with a return of 18.5%. Consistent with recent trends, a handful of companies drove those returns. While we saw some life from value names at times during the quarter, familiar names such as Facebook, Amazon, Apple, etc. resoundingly led markets higher. Of the broad indices, the tech-heavy NASDAQ lead all with a gaudy 30.9% return.
While the quarter saw a broader section of the market do well, diversification in general has not helped returns halfway through the year. Anything outside of large, technology-based businesses has struggled. The bifurcation is easily observed when comparing the returns of the Russell large cap growth and value indices. Growth stocks are now up year- to-date (YTD) over 9.8%, while value companies are down 16.3%. While a diversified global equity portfolio posted a very good return of 19.4% for the quarter, the year-to-date return of -6.0% lags the S&P 500.
While some areas of the market had very strong quarters, their returns year-to-date remain fairly depressed. MLPs, which were easily the best performing major asset class, were up over 50.1% but remain down 35.7% for the year. Small companies also were top performers as the Russell 2000 came in at up 25.4%, but year-to-date returns are a negative 13.0%, a return of almost 10% behind the S&P 500.
Internationally, the story was similar. Both the MSCI EAFE (developed international) and MSCI EM (emerging markets) indices had double digit returns, but lagged the domestic markets. Year to date, developed international stocks are down -11.0% and emerging market names performed slightly better with a -9.7% return. With Europe beginning to emerge from a devastating shutdown, the region is cautiously attempting to return to normal but remains far from achieving that goal. With the virus rapidly increasing in Latin America, places like Brazil seem on the front end of the curve and have a long way to go. The one bright spot is China, which makes up about a third of the emerging markets index. The country continues to report very limited impact from the virus and outside sources, like mobility data, seem to support that position.
There comes a time in every man’s life, and I’ve had plenty of them.
- Casey Stengel
This little gem of Stengelese might appropriately paint a picture of all the ups and downs we’ve had the past few months. Often, we have seen events which initially appeared as inflection points and magnitude. However, this quarter should help define our situation a little better.
As we enter into the Second Quarter earnings season, investors will learn a lot about the initial impact of shutdowns on corporate results. While Wall Street analysts are doing their very best to predict those results, we are likely to see actual numbers vastly different than expectations. As of writing this update, according to Factset, expectations are for earnings results of -43.9%. If results come in at this level, it will be the worst quarter since Q4 2008 (-69.1%). This latest projection is a far cry from the -13.6% for the Second Quarter analysts were expecting as of March 31.
Wall Street expectations always have a level of inaccuracy, however, uncertainty going into this quarter is elevated. While analysts talk with company leadership and do their best to model out expectations, even those leaders appear uncomfortable setting expectations. For this quarter, only 49 companies in the S&P 500 bothered to issue guidance. This is important because as we get results, stocks are likely to see meaningful shifts in price once this data is released. Even more, the earnings calls will begin to paint a clearer picture of the challenges these companies are facing and their ability to navigate them.
You better cut the pizza in four pieces because I’m not hungry enough to eat six.
- Yogi Berra
The value of an item is only as much as a buyer is willing to spend at a given point in time. That number can vary wildly depending on the availability of information. Stocks are not removed from this condition and the availability of information helps define the efficiency of these markets. When information is not available or when there is an asymmetry of information, stocks can trade at otherwise unreasonable prices. Yogi maybe adds a different factor - incorrect processing of accurate information.
With the uncertainty surrounding almost every input, investors face extreme difficulty in making smart decisions. Based on what the street expects for earnings, stocks look expensive. The forward P/E of the S&P 500 ended the quarter at 24.9x as compared to the 25-year average of 17.4x. This current valuation is at a level not seen since the end of the tech-bubble in the early 2000s. However, this process of valuation relies heavily on the accuracy of earnings expectations we referenced earlier. If we average long-term historical earnings in an effort to remove the inherent fallacy of projections and use Robert Shiller’s cyclically adjusted P/E (CAPE), the market is trading at 29.0x. At that level it is also unusually elevated, but we were higher near the end of 2018.
The current valuation concerns are not exclusive to U.S. Large Cap companies. Small Cap companies appear to trade at astronomical levels, despite a double- digit negative return for the year. With the strong quarter, the forward P/E comes in at astounding 182.9x earnings! When PE ratios are this absurd, it indicates many small cap companies have earnings that are negative or approaching zero. This can happen in times of stress. Keep in mind the long-term P/E average comes in at 26.3x. If someone is simply investing in areas of the market which have underperformed, they may find themselves buying this group of stocks at what appears as historically high prices.
Where does this leave us? You can assume this disconnect can’t last – either the price of the market should decline or earnings will come in well ahead of current estimates. Nevertheless, there is certainly one other factor at play – monetary policy. With the aggressive actions taken by the Fed to ward off disaster, we are once again dealing with all-time low interest rates. We are also dealing with low and declining inflation expectations. These factors should warrant higher multiples. The question is what is too high?
When you come to the fork in the road, take it.
- Yogi Berra
While Robert Frost may have rolled over in his grave at that quote, we seem to have come to several forks over the past few months. Different areas of our country have taken different paths, but there are all intertwined and we will likely all end up at the same destination – wherever that may be. Although Second Quarter corporate results will matter, much of our expectations for market returns will hinge on the impact of COVID-19. Globally, countries are all on very different paths. However, the interconnectivity of our planet makes those experiences meaningful to all nations. We’ve seen this play out in the U.S. as much of the Tri-State area dealt with the initial brunt of infections, but the rest of the country saw milder exposure. This trend has now reversed as infections in other regions have significantly increased.
With this event, the economic picture remains importantly tied to these trends and governmental policies in response. Increasing lockdowns over time will inevitably result in stickier unemployment. This one factor of employment will ultimately dictate how our economy fares. Various levels of the government have the unenviable position of balancing public wellness with economic disaster. While we hope for a perfect solution, it is unlikely that any one course of action will emerge as the clear choice. We will continue to see starts and stops along the path, and missteps will likely remain as common as beneficial actions. Despite this environment, good companies will continue to improve and be in position to prosper as we eventually do conquer this challenge.
Never, ever bet against America.
- Warren Buffett
The Oracle of Omaha has a frankness of words not entirely dissimilar to those baseballisms in his ability to make complex ideas simple. His clear-eyed view is one which has unequivocally reaped a record of demonstrated success. While we warned earlier this year not to extrapolate extreme market emotions, Mr. Buffett also reminds us we have faced many similar or worse challenges in our nation’s history. While the road was not easy, our ability to withstand adversity and prosper has been our hallmark. During Berkshire Hathaway’s recent shareholder meeting, Mr. Buffett spoke of the many crises we’ve seen over the past 244 years, but more importantly he illustrated how we’ve succeeded. While this crisis is far from over, and market volatility is almost certain, history suggests we will get through this and will likely come out a stronger and more prosperous society. In that scenario, stocks will almost certainly provide the best return for investors. Until we get through this, we will continue to position our portfolio with diversified, high quality assets capable of weathering the current storm.
Details you need to make a smart decision
BBVA is the trade name for BBVA USA, Member FDIC, and a member of the BBVA Group. Securities products are NOT deposits, are NOT FDIC insured, are NOT bank guaranteed, may LOSE value and are NOT insured by any federal government agency.
This material contains forward looking statements and projections. There are no guarantees that these results will be achieved.
Investing involves risk including the potential loss of principal. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary. Therefore, the information presented here should only be relied upon when coordinated with individual professional advice.
Indexes are unmanaged and investors are not able to invest directly into any index.
International investing involves special risks not present with U.S. investments due to factors such as increased volatility, currency fluctuation, and differences in auditing and other financial standards. These risks can be accentuated in emerging markets.
Investments in stocks of small companies involve additional risks. Smaller companies typically have a higher risk of failure, and are not as well established as larger blue-chip companies. Historically, smaller-company stocks have experienced a greater degree of market volatility than the overall market average.
Equity investments tend to be volatile and do not involve the guarantees associated with holding a bond to maturity.
In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors.
The investor should note that vehicles that invest in lower-rated debt securities (commonly referred to as junk bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default.
Municipal bond offerings are subject to availability and change in price. If sold prior to maturity, municipal bonds may be subject to market and interest risk. An issuer may default on payment of the principal or interest of a bond. Bond values will decline as interest rates rise. Depending upon the municipal bond offered, alternative minimum tax and state/local taxes could apply.
The price of commodities is subject to substantial price fluctuations of short periods of time and may be affected by unpredictable international monetary and political policies. The market for commodities is widely unregulated and concentrated investing may lead to higher price volatility.
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Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), BofA Merrill Lynch U.S. Treasuries 1-10 years, BofA Merrill Lynch U.S. Agencies 1-10 years, BofA Merrill Lynch U.S. Corporates 1-10 years A-AAA, BofA Merrill Lynch U.S. Municipals 1-10 years A-AAA, Russell Top 200 Index, Russell 1000 Index, Russell Midcap Index, Russell 2500 Index, Russell 2000 Index, Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).