Does the current rally have legs? It comes down to simple(ish) math.

Our Top Market Takeaways for April 28, 2020.

Market Update

Markets got off to a strong start on monday

The S&P 500 gained +1.5%, the Stoxx Europe 600 gained +1.7%, and 10-year U.S. Treasury yields rose by six basis points. Under the hood, recent laggards (financials, real estate, materials and industrials) led the way, while recent leaders (technology, communication services and consumer staples) lagged. It seems like short covering could be why the laggards were leaders yesterday (a basket of the most shorted stocks was up almost 3%), but the yield curve (which financials are sensitive to) also steepened yesterday. So does the rally have legs? Let's take a look at five stats we think provide an answer.

Spotlight

5 stats to know this week

1)    Nine states are currently relaxing COVID-19 related restrictions, and seven more have stay-at-home orders expiring on April 30. Risk markets are rallying in part because they perceive that the worst of the economic shock has passed. Indeed, it seems logical that economic reopening, even if staggered and gradual, is an improvement over the drastic decline in activity during the last six weeks. The nine states that are currently reopening (Alaska, Colorado, Georgia, Minnesota, Mississippi, Montana, Oklahoma, South Carolina and Tennessee) made up ~11.5% of 2019 GDP, and the seven others that have orders expiring on April 30 (Alabama, Arizona, Florida, Idaho, Maine, Nevada and Texas) made up another ~18%.

2)    However, 35 states have either not reached their peaks in new COVID-19 cases, or are still plateauing. One way to assess the differences between states is to compare the current seven-day average case growth rate to the peak growth rate (to get a sense of how far past the peak in new cases they are). For example, New York is currently 39% below peak based on this metric (chart below). You can also get a sense for the severity of the outbreak by comparing the cumulative cases per one million residents (New York has ~13,800 cases per one million people).

The line chart shows the number of new confirmed cases on a rolling seven-day average for New York from March 8 through April 27, 2020.

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The results of this analysis are below. The worst, most mature outbreaks (New York, Louisiana, Michigan) are visible in the lower right side of the chart, while states that are well past the peak and had relatively mild outbreaks are on the lower left (Alaska, Hawaii, Montana, Vermont).

The most important takeaway is that only 15 states are markedly “improving”—meaning, their current seven-day average case growth is more than 30% below what it was at the peak. This suggests that 35 states are still either peaking or plateauing. The good news? An increase in testing could help explain the stubbornly high plateaus. On Sunday, April 19, 151,928 tests were administered in the United States. On Sunday, April 26, 218,112 tests were administered. According to Michael Cembalest, almost 80% of states (in terms of 2019 GDP) have new case rates that are either falling or rising slower than tests are increasing.

The scatter plot shows the percentage difference between the seven-day average daily new COVID cases and the peak in daily new cases by state. The higher up on the y-axis a state is, the closer it is to peaking. The farther right on the x-axis shows a more severe outbreak, as the x-axis shows the cumulative COVID-19 cases per one million people.

3)    Only 27% of respondents to EvercoreISI’s investor survey (one of the most widely followed in the industry) expect the next 10% move in the S&P 500 to be “up.” The stock market has rallied almost 30% from March 23 lows, and it seems like most investors don’t think the rally can go much further. Mutual fund manager positioning seems to align with this story. Mutual funds are holding 5.9% of their funds in cash (the highest since 9/11), and money market fund assets under management (AUM) have expanded by $1 trillion over the last eight weeks—the largest two-month change dating back to 1990. Investors are uncertain, and it is showing up in a rush to the sidelines. Perhaps it’s the dire economic news that has them worried. The weighted average Q2 GDP growth forecast for the United States is -31.6%. The lowest is -65%.

4)    The five-largest stocks in the S&P 500 make up a larger share of the index than the bottom 350 stocks combined. In fact, the top-five stocks make up a higher share of the index than at any time since 1980. Investors are seemingly entrusting their capital to the biggest companies in the hope they are best positioned to weather the economic fallout and perhaps even gain market share. While the S&P 500 is only 17% from its February all-time high, the median stock in the index is still more than 28% below its respective peak. The market cap weighted S&P 500 has outperformed the equal weighted index by 7.6% so far this year, and small caps have underperformed by 12.5%. Large cap stocks in the United States may be making a “V” shaped recovery, but small caps, so far, are taking an “L.”

The line chart shows two lines: the S&P 500 Index and the Russel 2000 Index, both indexed to 100 as of December 31, 2019. It shows these indices from January 1 through April 27, 2020. Both have followed a similar pattern, but the Russel 2000 is currently below the S&P 500, though both are trending upward.

5)    Those five-largest stocks all report earnings this week, and options markets are expecting they will move by +/- ~5% or more after their releases.

So what do we make of all this? Caution seems consensus, as evidenced by the high levels of cash in money market funds and in mutual fund allocations, as well as the reticence of investors to allocate capital toward “cyclical” sectors that traditionally benefit at the beginning of a recovery (like small cap stocks or industrials). Instead, investors are flocking toward stocks they think will be able to survive or even thrive as the world economy enters the new normal.

While the intensity of the COVID-19 crisis has probably peaked, we are still far from realizing the full effects of it. In the end, it comes down to simple(ish) math. The S&P 500 is trading at a historically elevated multiple on the same level of earnings that the index mustered in 2019—in the midst of a global pandemic. That being said, we feel that taking risk in the short term is better served investing in the sub-sectors we think will drive the recovery, or in other assets that offer more compelling risk/reward profiles. Here, you get a bonus stat: If BB-rated high yield defaults double what the worst annual default rate was back to 2000, a hold to maturity investor would end up flat. This tells us that there is a large degree of protection even if a lot does go wrong. At the index level, equities do not seem to have the same margin of safety.

 

 

All market and economic data as of April 2020 and sourced from Bloomberg, FactSet and Gavekal unless otherwise stated.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.

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