The second quarter delivered the positive investment returns that investors had been hoping for since the first quarter stock rout. The major stock indexes rebounded significantly from the March selloff precipitated by the Covid-19 pandemic. Even in the midst of a shuttered economy, increasing Covid cases, and uncertainty if a return to normal would ever occur, stocks were able to generate much higher than average quarterly returns. Large technology companies that had performed the best prior to the Covid pandemic maintained that relative outperformance during the pandemic. Although these large technology companies (most notably Facebook, Apple, Amazon, Netflix, Google, and Microsoft – aka FAANGM) are very expensive and approaching maximum value, they are also uniquely positioned for a pandemic. The products and services these companies provide are in higher demand during shelter-in-place orders. They can also easily transition employees to remote work environments. No surprise – the NASDAQ was the best performing index for the quarter with a total return of 30.95%. The Russell small cap also emerged from the ashes to post a three-month return of 25.42%. International stocks were a relative laggard as the MSCI EAFE only managed to produce a 15.15% return during the same period.
In other financial markets oil ended the second quarter higher, interest rates languished at historically low levels and gold move significantly higher. Oil prices initially plunged as the Covid Pandemic and shelter-in-place response throttled almost all forms of travel. Oil touched an intra-quarter low of $25.86 per barrel on April 22nd before climbing to $39.58 at quarter-end. This resulted in a second quarter total return of 20.26%. Interest rates sunk in the first quarter as it became clear economies around the world would pause in 2020. This was further solidified as the U.S. Federal Reserve dropped the Fed Funds rate to 0% on March 15th. Interest rates remained at miniscule levels for the entire second quarter. The U.S. Government 10 year Treasury note started the quarter yielding .67% and finished the quarter yielding .66%. Gold was also a winner as heightened fear pushed more investors into tangible assets. During the second quarter gold gained 10.05% and is now up 17.21% for the year.
Looking Forward –
As the U.S endured the shuttering of the world’s largest economy and unemployment rates exceeding 13%, the effect on stocks was perplexing. The most risky and expensive stocks prior to the Covid-19 Pandemic were the FAANGM stocks as mentioned previously. Historically, less expensive (low price-to-earnings and low price-to-book) dividend paying stocks defend the best during periods of uncertainty. This was not the case during the pandemic. Investors tossed out investment fundamentals and financial analysis and allocated funds based on familiarity, popularity, and a misguided understanding of intrinsic value. The FAANGM stocks have become the comfort food of investments. Buying them makes you feel good but owning them is not really good for you. This momentum trend can last for a while but usually ends badly. The Major dislocation between FAANGM stocks and everything else is evident in the difference between Exxon and Apple: energy giant Exxon generated $255 billion in revenue in 2019. Technology juggernaut Apple generated $260 billion during the same year. Apple has a forward price-to-earnings ratio of 35 times, a price-to-book ratio of 27 times, pays a dividend of just .70% and is valued at $1.9 trillion. Exxon has a forward price-to-earnings ratio of 22 times, has a price-to-book ratio of .80 times, pays a 10% dividend yield, and is valued at $144 billion. Apple should get a slight premium for growth and pricing advantages. However investors cannot ignore forever an opportunity to own similar revenue at a tremendous discount and receive an annual dividend of 10%.
What does the Apple and Exxon comparison mean for investors for the remainder of 2020 and into 2021? It means that an unsustainable gap between growth stocks and value stocks has emerged and alert investors have the potential to reap major benefits. There will be a rotation from growth to value as the economy continues to recover from the pandemic. Passive index investing will give way to active stock pickers as price discrepancies are exploited similar to Exxon and Apple. Stock strategies should continue to include securities that can absorb inflation as government stimulus and 0% interest rates spark the economy. Bond investors need to remain short and seek alternatives to U.S. Treasury debt. Municipal bonds continue to provide relative benefits to as yields are more than 100% of equivalent treasuries.