The third quarter continued the trend of recouping the losses from earlier in the year. Prior to the Covid 19 crisis in the United States, the Russell 3000 (broadest measure of U.S. stock prices) was at 1,984 on February 19, 2020. This level quickly diminished as Covid 19 fears spread and shelter-in-place orders were rolled out. The index struck a bottom at 1,288 on March 23, 2020. At the end of the third quarter the Russell 3000 stock index had rebounded to 1,968. This put the index within 1% of completely retracing back to the 2020 high in February. Among the sectors and asset classes, the story remained the same and the large cap technology bubble continued to expand. The NASDAQ gained 11.23% in the third quarter and the S&P 500 and Dow Jones Industrial Average gained 8.93% and 8.22% respectively. Small cap and international stocks experienced above average quarterly returns but lagged the “super-star” returns of any index containing a high allocation to large company technology stocks. The Russell 2000 Small Cap posted a third quarter return of 4.93%, while international stocks (MSCI EAFE Index) appreciated 4.87% during the same period.
Although the strong stock market performance remains baffling to many, it is rooted entirely in logic. Stock investors are forward looking and are bidding up the current value of stocks because twelve to eighteen months from now the economy should be humming. The U.S. Presidential election will be over, some form of a covid 19 vaccine will exist, and there will be an incredible amount of pent-up consumer demand. Combine this with virtually 0% interest rates and massive government stimulus and it should be a fertile environment for global economies. Roaring 20’s?
In other financial markets interest rates, gold, and oil were little changed. All three edged higher as potential inflation continues to creep into investor’s consciousness. During the third quarter the yield on the 10 year U.S. Government bond went from .66% to .69%, the price of a troy ounce of gold went from $1,784 to $1,897, and a barrel of oil went from $39.27 to $40.22.
Looking Forward –
The stock market is increasingly becoming bifurcated. The divide is between expensive and inexpensive stocks. For regular readers of this Economic Perspective, this is not a new development. However, the gap between expensive and inexpensive stocks has expanded greatly in the last several months. The price-to-earnings ratio (P/E) is the most common measure of expensiveness. This ratio reflects how many times higher the price of the stock is than the net income (earnings). Historically, the average P/E for the general market (S&P 500) is around 18 times. As you can see in the table below the right side indices all have P/E ratios well in excess of the historically average. The commonalty of these indices is that they are all highly allocated to large cap technology stocks. The indices on the left side have virtually no exposure to large cap technology stocks. The left side indices all have P/E ratios below average. The other defining element of these two groups of indices is that the ones on the left side are characterized as value and the ones on the right as growth. By borrowing the old adage: buy low and sell high, it is obvious low is in value and high is in growth.
Since the market decline in the first quarter, investors have refused to abandoned the concentration to expensive large cap technology stocks in favor of the inexpensive (and high dividend paying) value stocks. A common explanation is that the large cap growth stocks like Facebook, Google, Apple, Netflix, Amazon, and Microsoft are all perfect for a pandemic and a stay-at-home lifestyle. These firms can easily adapt to effectively manage a remote workforce. All these firms also provide services that have seen demand increase as a result of the pandemic. These should make for perfect investments, right? Probably not if you consider how much equity ownership (shares) are now costing investors. It is very difficult for investors to separate great companies from great stock investment opportunities. They can be very different. By any definition Microsoft, Facebook, Apple, Amazon, Google, and Netflix are great companies. They are the iconic brands of the current generation. However, this group of stocks doesn’t continue to offer the best risk/return proposition.
For the remainder of the year investors should continue to limit their exposure to large cap technology stocks. For individuals who own mutual funds, Exchange Traded Funds, and individual stocks, it is critical that they examine the underlying stock positions and scan for concentration risk. Many funds actually hold the exact same investments as each other and the portfolios are needlessly undiversified.
D’Arcy Capital is beginning to see new opportunities in the energy sector. This sector has been beaten down the last several years but now shows potential to outperform. The financial sector, emerging markets, small cap stocks, and value stocks also look attractive. Large cap growth, utilities, and U.S. Government bonds remain underweights. Municipal bonds, inflation protected bonds, and high yield bonds remain the best options in the fixed income world.