Commentary | 3Q 2020
Q3 2020 Market Recap
In the third quarter of 2020, the stock market, as represented by the S&P 500 Index, produced a return of 8.93%. The market continued its rebound from the steep decline of the first quarter, and by the end of the third quarter, the S&P generated a year-to-date return of 5.58%.
The market continued to experience an elevated level of volatility in the third quarter. The VIX Index, a popular measure of volatility, ended the quarter at approximately 27. This level is down substantially from the level of nearly 78 reached when the market fell in March, but well above the beginning of the year level of 14. The market’s volatility reflected the uncertain outlook for economic activity and usual Presidential year policy debates.
The stock market’s advance was not uniform across financial characteristics or size. Stocks classified as growth stocks (S&P 500 Growth Index) experienced a return of 11.8% in the most recent quarter and a return of 20.6% year-to-date, while stocks classified as value stocks (S&P 500 Value Index) returned 4.8% in the most recent quarter and -11.5% year-to-date. The 32.1 percentage point spread between the returns produced by the two different types of stocks is large when compared to the longer-term differential in returns. While the differential in favor of growth stocks has persisted for 20 years, the differential for sub-periods has typically been much less. Over the last 20 years, growth stocks have on average produced a 1.50 percentage point higher return than value stocks. The enlargement of the differential has been attributed to the performance of a small group of large capitalization stocks concentrated in industries that benefit from an expansion of consumer disposable income both in the United States and overseas.
The spread in returns of small stocks versus large stocks favored large capitalization stocks in the third quarter. Small stocks (S&P SmallCap Index) produced a return of 3.2%, well below the 8.9% return of the overall market (S&P 500 Index). For the year-to-date period, small cap stocks returned -15.2%, 20.8 percentage points less than the return experienced by the overall market. Using longer-term data as a benchmark this return differential is an anomaly. Over the last 20 years, small capitalization stocks have generated returns that are, on average, almost 2 percentage points higher than those experienced by large capitalization stocks. As was the case with the large growth stock versus value stock differential, the near term spread between large capitalization stocks versus small stocks can be attributed to the same group of well-known names: Microsoft, Apple, Amazon, Alphabet, Facebook, and Netflix.
One of the most unusual conditions existing in the capital markets is the low level of interest rates. Interest rates on short-term government obligations remain close to 0.0%. Thirty-year government bond yields are about 1.6%. The yield curve remains flat when compared to historical yield spreads. Forward interest rates reveal the expectations of investors for economic activity, and given the shape of the curve currently, investors do not expect either robust economic growth or troublesome inflation rates. Historically, the level of long-term rates has been about 3.5 percentage points over the inflation rate which has averaged nearly 2.5%. At this time, it is difficult to see events which would lead to a rise in rates to levels consistent with the long-term average, but changes in economic policies fall in a wide range during Presidential election years. A continuation of the shape of the yield curve could be challenged if new policies are implemented.
The economic environment improved during the third quarter. By the end of the quarter, unemployment had fallen from over 14% at the height of the COVID-19 shutdown to 7.9%. The end of quarter level remained well above the beginning of the year level of 3.6%. While the economy created new jobs in the quarter, the total number of unemployed individuals is estimated to be 6.8 million higher in September than the number unemployed in February, and the unemployment rate is 4.4 percentage points higher than it was in February. These unfavorable comparisons are largely the result of actions taken to mitigate the effects of the COVID-19 pandemic. The restrictions placed on economic activity ended a pattern of economic growth that had been in place for almost eleven years. Preliminary estimates for the growth of real GDP in the third quarter are close to 35%. The increase would follow a first quarter decline of 5% and a second quarter decline of roughly 32%. Going forward, growth beyond the third quarter rebound will be difficult as the restrictions remain.
Any forecast of economic activity relies on some assumptions about the nature of future economic policies. In Presidential election years, the accuracy of these assumptions is challenged by the spread in policies offered up by each candidate. The policies of incumbents are more easily bounded than those of the challenger. In the case of the 2020 election, President Trump has had almost four years in which to put in place his economic policies, which have consisted of lowering tax rates and reducing regulations. During President Trump’s tenure, the stock market has produced an annual return of approximately 14.0%. This performance could be construed as a reflection of investors’ evaluation of his policies.
Vice President Biden has proposed a far different set of policies. He has promised to raise tax rates and eliminate “shareholder capitalism”. The proposed increase in tax rates would extend to capital gains and dividends as well as income. Vice President Biden has promised that he would raise tax rates on “day one” of his new administration. It is likely the economy would be in the middle of a fragile recovery as his tax increases were implemented in January. Vice President Biden’s proposal to disenfranchise shareholders is controversial and troubling. The reality of all election year proposals is that many do not survive the legislative process.
While Presidential candidates offer starkly different policies, the Fed has stayed the course, and there is no indication its policies will change. The money supply continues to expand at a rapid pace. Since the end of February, the Fed had added roughly 3 trillion dollars to its balance sheet. It seems prepared to expand its balance sheet even further.
The outlook for the stock market and the economy is always clouded by uncertainty. The primary driver of market performance and economic conditions is human behavior. Behavior is inherently a variable that is hard to forecast. In Presidential election years, behavior becomes more energized and can move outside of historic norms. The 1994 and 2010 election should serve to remind all that if counterproductive behavior dominates in any presidential election, the next election is only two years away.