Wednesday, July 8, 2020

July Market Update - Preparing for More Challenges

The S&P 500 gained 1.84% in June ending at 3100.29. YTD through June 30, the S&P 500 is down 4.04%. Before we review price, sentiment and valuation, I'd like to highlight two quotes from a speech Vice Chair for Supervision and Chair of the Financial Stability Board at the Federal Reserve Randal K. Quarles gave at the Exchequer Club in Washington, D.C. on July 7, 2020:
"We know that the financial system will face more challenges. The corporate sector entered the crisis with high levels of debt and has necessarily borrowed more during the event. And many households are facing bleak employment prospects. The next phase will inevitably involve an increase in non-performing loans and provisions as demand falls and some borrowers fail." 
"According to the latest International Monetary Fund forecast, the global economy is projected to contract sharply by 4.9 percent in 2020, a much worse outcome than during the 2007–08 financial crisis. While some indicators suggest a rebound in activity, the path of recovery remains highly uncertain."
The high level of uncertainty over the medium term will allow the Fed to keep rates lower for longer. I'll share more thoughts on the market and economy after we review price, sentiment and valuation.

 Price
Source: Advisor Perspectives, Moving Averages June Update

Jill Mislinksi wrote the following at Advisor Perspectives:
"All three S&P 500 MAs are signaling "invested" and three of five Ivy Portfolio ETFs — Vanguard FTSE All-World ex-US ETF (VEU), Vanguard REIT Index ETF (VNQ), and Invesco DB Commodity Index Tracking (DBC) — are signaling "cash."
This is the second month in a row that VTI and IEF have signaled "invested" while the remaining three ETFs (VNQ, VEU, and DBC) signal "cash." IEF has signaled "invested" since the end of November 2018. VTI has signaled "invested" since the end of May 2020. Reviewing the 5-month simple moving average compared to the 12-month simple moving average for SPDR® S&P 500® ETF Trust, symbol SPY, we see the following picture on July 1, 2020, using monthly price data:
Blue line = 5-month SMA; Orange line = 12-month SMA
Please click on graph to enlarge.

Notice two items on this graph. First, the rate of change of the 5-month simple moving average has started to move up off of a low formed in June 2020. Second, notice that the 5-month simple moving average crossing below and then above the 12-month simple moving average has captured periods of weakness in the economy over the last ten years.

Sentiment
Source: CNN Business Fear & Greed Index

The CNN Business Fear & Greed Index started the month of July with a reading of 47, measuring "Neutral" sentiment. On June 30 the previous close, one week ago, one month ago and one year ago sentiment readings were all "Neutral." As of this writing on July 8 the current reading is 53 still "Neutral."

Turning to the CBOE Volatility Index (VIX), it spiked up at the end of February 2020 and has remained elevated, above 25, since then. It is uncommon for this volatility gauge to remain over 25 for four consecutive months.

Valuation
Source: Advisor Perspectives, Is the Stock Market Cheap?

The P/E10 Ratios by Percentile graph shows P/E10 ratios are higher than 94.4% of prior readings. Long periods of time living in a world of high valuations and concentrated wealth has the potential for citizens to start laying the groundwork to turn the world upside down. Bitcoin is one example of people searching for an alternative method to store value and maintain purchasing power. More extreme examples of people trying to evolve how our economy functions include ideas like Seeds, a digital currency and financial system attempting to create an economic ‘Operating System’ for incentivizing an equitable and ​regenerative​ global society. My final point about how extreme valuation, concentrated wealth, low-cost computing power and rapid communication impacts societies is that it enables many creative people to start to think about alternative ways we can structure the economy. Facebook's Libra experiment is a great example of how technology is changing how people view assets, trading networks and currencies.

PSV (Price, Sentiment, Valuation) Summary
Price indicators currently show "invested" signals for VTI and IEF and "cash" for DBC, VEU, and VNQ. Sentiment according to the CNN Business Fear & Greed Index starts July measuring "Neutral" and the VIX remains elevated above 25. U.S. stocks remain expensive with positive returns concentrated in the largest U.S. growth companies.

Market Perspective
As Fidelity recently highlighted, it's time for the summer stock doldrums.
Please click on image to enlarge
Source: Fidelity Investments

Seeing this chart reminded me of the work of Jason Goepfert, who wrote the following at SentimenTrader.com on May 1, 2020:
"When the S&P was down 5% or more heading into the summer, the next 6 months averaged -1.4% with a 47% win rate, compared to an average of +3.6% and 74% win rate during up years. Seasonality is a tertiary input at best, but it suggests that upside over the summer months might be hard to come by given the already-weak conditions."
Regarding U.S. large cap stocks, the gains continue to concentrate in a few mega cap stocks. July 6, 2020, Ben Carlson posted Explaining the 2020 Stock Market on his blog A Wealth of Common Sense. He created the following table which examines the S&P 500 broken down by market cap showing the median size, price-to-earnings, prices-to-sales, price-to-cash flow, price-to-book value and year-to-date returns through July 3, 2020. He wrote:
"There is a clear pattern at work here. The biggest companies by market cap are the most expensive by traditional valuation metrics and they also have the best returns this year. The smallest companies by market cap are the least expensive by traditional valuation metrics and they also have the worst returns this year. The market doesn’t always line up so perfectly by size but this year’s performance attribution is crystal clear."
Please click on the table to enlarge
Source: A Wealth of Common Sense Blog

Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc., recently wrote in her June 29, 2020 market commentary, Pause: Stocks' June Consolidation Continues (please read her Don't Fight the Fed? section of her commentary to review the charts she references in the quote below):
"I won’t claim direct correlation (or even causation), but as you’ll see in the first chart below, the peak in the S&P 500 also came within the same time frame as the recent peak in the Federal Reserve’s balance sheet (which has had two consecutive weeks of slight declines). Related, the peak in the S&P 500 also came just after the peak in the 13-week percentage change in M2 money supply, as you can see in the second chart below. In essence, the “shock and awe” stage of Fed policy announcements is, for now, in the rear-view mirror."
This idea of the "shock and awe" stage of Fed policy being behind us reminded me of what I wrote in my March 2020 update, "With limited and aggressive central bank tools left, I suspect many investors will start appreciating gold again in their portfolios." When investors sense that stocks are expensive, bond yields are extremely low, corporate and high yield bonds still include many entities that may be at risk of going bankrupt, digital assets are a bit too exotic (at least for now for most investors) and developed economies are stuck in slow growth thanks to poor demographics, one of the main stores of value is gold and precious metals.

Economic Perspective
During Randal K. Quarles' speech, referenced at the beginning of this update, he stated: "The policy response by central banks and governments to this liquidity shock was rapid and decisive. The authorities worked together to address the problem through a combination of monetary, fiscal, and regulatory measures. These interventions led to rapid improvements in financial markets."

The economic uncertainty associated with living through a pandemic has resulted in the easiest monetary policy conditions the earth has ever seen. On June 30, 2020 Charlie Bilello, CEO and co-Founder of Compound Capital Advisors, wrote a tweet highlighting that 84 central banks have cut rates in 2020. Central banks lower rates in an attempt to stimulate economic growth. The logic is that lower financing costs encourages market participants to borrow and invest. However, when rates are too low, they can provoke excessive growth and subsequent inflation, reducing purchasing power and undermining the sustainability of the economic expansion. With 84 central banks lowering rates in the same year, some economic observers are concerned this will create conditions for stagflation (when growth is slow but prices of goods and services are increasing). At present, given fear of a deflationary, low demand economy the Federal Reserve and all 84 central banks that reduced interest rates would much rather see stagflation than attempt to combat deflation.

For the United States of America the core of the deflation worry reveals itself in labor statistics. The U.S. economy has experienced 15 consecutive weeks of over one million initial weekly jobless claims; the worst weekly reading for initial jobless claims during the 2007-2009 recession was 626,000 for the week ending January 31, 2009 reported on February 5, 2009.

Please click on the chart to enlarge
Source: Trading Economics

For a consumer led economy, lack of demand due to loss of work and/or lowering wages creates major obstacles. As the pandemic lingers it has large structural impact on society and the economy. Examples:
  • Less use of public transportation.
  • Solvency risk for many businesses, especially small businesses.
  • An increase in non-performing loans.
  • Increases in bankruptcies, both personal and corporate.
  • Loss of tax revenue for states and municipalities.
  • Less demand for postal services, creating possible job loss at the postal service.
  • Strain on assisted living and eldercare staff and residents.
  • Lower demand for air travel and hotel stays, creating possible conditions for more job loss.
  • Closure of many indoor recreational facilities, including movie and live theaters.
  • Early retirement and additional strain on Social Security and pension systems.
  • Strain on healthcare facilities: Treating COVID-19 patients and non-COVID patients postponing care.
  • Increase in sales of above ground pools, boats, golf push carts, bicycles and any equipment needed for local outdoor activities one can experience while social distancing.
  • Sporting events halted or modified.
  • More demand for road trips and local travel than foreign trips.
  • Less business travel and more virtual meetings.
  • Strain on parents, daycare facilities, educational facilities and staff.
As always, wise investing my friends.
Please consult a qualified financial advisor before making any investment decisions. This blog is for educational purposes only and does NOT constitute individual investment advice.
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Here's what I've been reading, watching and listening to recently:
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