The stock market’s movements so far this year can best be described as weird. That may not be an apt technical definition, but there’s no better way to put it.
The stock market dropped 35% in 31 days, and then recovered all of its losses just five months later. The S&P 500 is now close to its all-time high, which was reached in early September, post-Covid.
There is still much uncertainty in the economy. Job loss is still a pervasive issue, businesses continue to struggle, and parts of the economy are still effectively paralyzed either by government fiat or consumer choice.
This seems like an odd environment for stocks to be achieving all-time highs. However, a look beneath the surface does offer some insights. The S&P 500 index has indeed achieved all-time highs, but other market segments, including midcap, small-cap, international, and value stocks are all still well below their previous records.
When looking at the stock market through our factor lens, value stocks have suffered the most during the downturn, and have been slow to recover. Low volatility stocks have done better than value but have still struggled. Quality stocks have performed roughly in-line with the S&P 500. And, momentum stocks have continued to dominate.
Momentum stocks currently include all the largest technology companies. Tesla, Apple, Amazon, Microsoft, Netflix, and Google are among the largest holdings in the momentum fund we own. These stocks have performed exceptionally well and have driven the overall stock market to new heights.
However, the overall market’s gains seem fragile, as only a relative handful of stocks have accounted for literally all of the gains. The dominance of the technology stocks is starting to feel a lot like the technology boom of the 1990s, and indeed, by some valuation metrics it is worse today. Investors have largely focused their attention, and their dollars, on the largest, but also the most overvalued, and in some cases the least profitable stocks. That doesn’t seem sustainable. Over time the cheapest, most profitable stocks have generated the best returns for investors. It seems likely the pendulum will swing back that way before long.
Also supporting eye-popping valuations in some segments of the stock market is today’s historically low interest rate environment. We have data going back to the late 1700s, and interest rates have never been even close to as low as they are now. The 10-year Treasury bond yields a paltry 0.75%, and even that is up from the 0.50% it was yielding back in March. Bond prices go up as interest rates decline, so this year has actually been pretty good for bond investors. However, the outlook is less rosy. It is possible that interest rates decline from here, or even go negative, but we believe the odds of rising rates is stronger, and a greater risk.
Just over a year ago, in July of 2019, the 10-year Treasury yield was over 2.0%. It was above 3.0% in November of 2018. Over the very long term, rates have averaged closer to 5.5%. It would not be surprising to see interest rates start to return to more “normal” levels before long. The catalyst could be a continued economic recovery, additional government stimulus that degrades the credit quality of the U.S. government, or any hint of inflation. The Fed has signaled its intention to keep short-term interest rates low for some time, but the Fed does not set longer-term rates. Market forces will ultimately dictate longer-term interest rates, and as we’ve seen, market forces can take effect quickly.
The third quarter of 2020 was a solid one for investors if viewed in a vacuum. Most stock market segments rose in value, as did bonds. However, when viewed over the year-to-date period, the markets still have a lot of catching up to do. There seems to be a shift in market leadership getting underway, but much will depend on if and how the economy recovers in coming quarters.
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