Commentary | 2Q 2020
Q2 2020 Market Recap
In the second quarter of 2020, the stock market, as represented by the S&P 500 Index, produced a return of 20.5%. This return represented a healthy rebound from the first quarter decline of -19.6%. At the end of the first six months of the year, the Index had produced a return of -3.1%.
The market has been highly volatile in 2020 as participants wrestle with the consequences of the COVID-19 pandemic, and potential consequences of a Presidential election this November. The CBOE Volatility Index, VIX, a popular measure of the market’s volatility, began the year at approximately 13, and then rose to nearly 83 by mid-March before ending the second quarter at 29. The peak value of 83 coincided with a precipitous drop in the market as the pandemic began to affect public policies, and was the highest value attained by the measure in the last ten years. The daily average for the VIX thus far in 2020 is about 33 which is the highest daily average in ten years. Volatility at levels experienced thus far in 2020 have not been visited since the market collapse of 2008/2009.
The high volatility was accompanied by a disparate experience across market sectors as investors appeared to seek safe havens. For the first two quarters of the year, the S&P Growth Index rose 7.9% while the S&P Value Index fell 15.5%. Large differentials in the returns generated by large cap growth stocks and large cap value stocks tend to be reduced or eliminated over time. In the last 20 years, the S&P Growth Index has generated an average annual return of 5.9%. Over the same period, the S&P Value Index has experienced an average annual return of 5.7%. The S&P Small Cap Index faired far worse than the overall market in the first six months of 2020; it returned -17.9%. As is the case with the short-term negative return differential for value stocks, the small stock return deficit tends to move to zero over time. Over the last 25 years the S&P 500 Index has produced an average annual return of 9.7% while the S&P Small Cap Index has experienced the same average annual return of 9.7%.
The return experienced by the Growth Stock Index reflected, in large part, the performance of a small group of stocks with familiar names: Microsoft, Apple, Amazon, Alphabet, Facebook, and Netflix. The ten largest stocks in the Index represented about 42.5% of the total capitalization of the Index. This concentration of capitalization in a few names is found in the overall market index as well. The ten largest holdings in the S&P 500 constitute approximately 27.0% of the Index’s capitalization.
Investors sought refuge in a few names with the hope these companies could withstand the economic dislocations brought on by public policies put in place to mitigate the impact of COVID-19 on the health of the general population. The concentration of portfolio holdings when uncertainty is increasing is not unprecedented. During the period from the mid-1960’s until the market declines in 1973 and 1974, a phenomenon termed the “Nifty Fifty” arose. The phrase referred to a loosely defined group of stocks expected to survive the economic turmoil of the period. The Nifty Fifty were termed one decision stocks, buy them and never sell them. It was assumed they were destined to grow in value far into the future. Within this framework for expectations, the capitalizations of these stocks increased as they experienced above market returns, and they became most of the capitalization of the S&P 500.
As has been the case for most of the history of the stock market, small subsets of the market do not sustain above average returns indefinitely. Changes in economic policies and economic conditions ultimately lead to changes in market leadership. As inflation accelerated and real growth faltered, the S&P 500 declined -34.0% over the 1973 through 1974 period. After this market break, the Nifty Fifty lost its leadership status. Most notably, small cap stocks produced higher returns than the market average until sometime in the second half of 1982, when the market broke out of a 17-year long bear market. What changed in the latter part of 1982? The most obvious answer is inflation was beginning to slow, and a recession was ending, whereas in the period from 1965 through the first half of 1982, the economic trends were reversed. This difference was not the result of happenstance. A new Fed Chairman who had a well thought out plan to combat inflation was in place, and a new Administration with plans to increase real growth had come into office in 1981. The difference in the macroeconomic environment proved to be favorable for stock returns. In the period from June of 1982 through June of 2020, the S&P 500 produced an average annual return of 11.9%. There can be little doubt changes in economic policies have a pronounced impact on stocks returns.
Currently, economic policies are driven by efforts to mitigate the consequences of the COVID-19 pandemic. We have experienced a major increase in unemployment and a large decline in real GDP, as a direct result of policy choices. At the end of the second quarter, unemployment stood at 11.1%. Real GDP might have declined at a 35% annual rate during the quarter if early estimates are accurate. There was some positive economic news during the quarter. In June, an estimated 4.8 million jobs were created as COVID-19 related restrictions on economic activity were relaxed.
Corporate profits have fallen as economic activity declined. The consensus estimate calls for a decline in profits of 44% at an annual rate in the second quarter. Any estimates for changes in profits going forward are no more than guesswork. Economic policies are now driven by the course of the pandemic about which little or nothing is knowable.
When uncertainty seems to completely obscure the future, there are some long-term perspectives which should help shape expectations. The New York Stock Exchange was established in 1792 not long after the Constitution was ratified, and George Washington was President. The Exchange has continued to function for 228 years through the War of 1812, the Civil War, World War I, World War II, the Cold War and numerous smaller military conflicts. It has functioned through numerous economic dislocations including the Great Depression, and the near financial market collapse of 2008/2009. There is no reason to believe that, over time, the stock market will not regain its footing and continue to function as it has in the past.