Uncharted Waters
In the United States and around the world, Covid-19 has threatened the health of people and economies. Medical facilities have been overrun by sudden waves of patients, deaths have occurred in large numbers, entire populations have been under stay-at-home orders, economies have ground to a halt and stock market volatility has risen to extreme levels. Peoples’ lives and daily routines have been completely upended, resulting in mental anguish and confusion for many. Clearly, these are very unusual times with no precedent or playbook in our lifetimes.
Although this new virus is unpredictable, we appear to be gaining ground. Sadly, more American lives have been lost in the initial outbreak than during the entire 19-year Vietnam War. However, we are heartened to see that the daily death toll, along with the aggregate number of new cases and hospitalizations, is now trending lower despite some recent localized outbreaks. Significant efforts and resources are being rapidly deployed to develop medical solutions. While full containment remains a distant goal, progress is being made on many fronts, including detection, monitoring, treatment and prevention.
None of us have been immune to the economic impact of our battle against this pandemic. With roughly 95% of the U.S. population under state-wide stay-at-home restrictions for most of April, GDP has contracted sharply and unemployment is skyrocketing. Virtually no business has been untouched and most face severe near-term headwinds. However, with the virus’ outbreak waning in parts of the United States and globally, economies are beginning to reopen. Lacking clear visibility of the risk or ultimate outcome, state and local governments are weighing the physical safety of their citizens against the health of the economy. Likewise, there is no hard data or clear consensus on the timing and trajectory of the economic recovery and whether it will be a “V-shaped”, “U-shaped” or a different type of recovery.
Investors shun uncertainty, so their knee-jerk reaction was to assume the worst and sell securities indiscriminately. This subjected markets to a rapid and severe decline which likely over-shot economic reality. From the high in mid-February to the low near the end of March, the S&P 500 plummeted 35%. Stocks have rebounded by 33% since then are now down 10% year to date. Domestic markets gained 13% in April, marking the strongest month for stocks since 1987 and the best April since 1938.
With the economy still contracting, the recent rise in the stock market highlights a clear disconnect between the two. There are numerous reasons for this dichotomy. Importantly, financial markets are forward looking. As global economies including ours begin to reopen, investors are looking to the future and focusing on the destination rather than the journey. Governments and central bankers are providing huge support mechanisms in the form of fiscal and monetary stimulus–trillions of dollars in the United States alone. Notably from a health care perspective, the virus’ near-term impact may have peaked, and researchers are making progress on testing, treatments and vaccines. Still, until we have greater clarity on the path of this public health crisis and our economic recovery, the appropriate market level remains opaque.
Investors are adapting to the new reality, identifying those companies which will fare better in this very different and quickly evolving era. A clear indication of this is the difference in performance between growth stocks with their steady earnings and stronger balance sheets versus value stocks which tend to be more cyclical and carry higher debt loads. Looking at the Russell 3000 Index which represents 98% of the U.S. equity market and is a barometer of the broad market, we see it is down 11% year-to-date, in line with the S&P 500. Separating the broad index into its growth and value components, though, tells a very different story. Growth stocks have fallen 3% while value stocks have plummeted 20% during this same time frame. In the Covid era, small companies may also face increased difficulties ahead against larger more entrenched competitors with better resources and easier access to capital. Not surprisingly, the Russell 2000 Index of small companies is down 21% year-to-date, versus a 10% decline for the Russell 1000 large company index.
As you are aware, we are long-term investors. Our equity portfolios focus on high-quality growth companies of all sizes. In total, our stocks outperformed the market last year. Those strong gains continued into this year pre-virus, and are still well ahead of the indexes throughout this turmoil. Avoiding the temptation to join the panic sellers is not an easy path to follow. While such a strategy might mitigate additional portfolio downside, it would have locked in losses during the darkest days. Knowing that we hold an abundance of well-positioned companies, we stayed invested, thus allowing our portfolios to enjoy the rapid market rebound. We fully acknowledge that no portfolio will ever be perfect. Over time with additional insights and greater clarity around this new environment, we expect to make adjustments to our lineup of stocks with no significant change to the strategy that has served us so well through the good times and bad.
In summary, the initial outbreak of the virus appears to have peaked. While economies are beginning to reopen, this process will not be without bumps in the road and a likely (and hopefully smaller) second wave of infections. Financial markets discount the future. Uncertainty will not be overcome until there is a full medical solution (vaccine, treatment and/or cure), which is not on the immediate horizon. Economic and public health related unknowns will keep stock market volatility elevated in the near-term. The strongest and best positioned companies will successfully navigate this storm. Our portfolios are constructed for this environment. As always, we are here to help you and answer any questions you may have.
Holger Berndt, CFA Director of Research hberndt@rssic.com
