Market Forecast 2020 (Mid-Year UPDATE)
MARKET STRATEGY: The opinions outlined in this 2020 forecast reflect the views of the portfolio management team as we enter into the second half of the year. We have been correctly positioned over the last ten years on the long-side of the market. However, the length of the bull phase, the amount of global uncertainty, the covid-19 pandemic and an uncertain election has us cautious with respect to directional certainty.
The market cycle above has played out over a longer than normal eleven-year bull phase and will either continue on its growth trajectory or will finally roll over if the financial markets reset due to the concerns stated above. If momentum weakens, due to uncertainty and the weakening of internal market variables, markets tend to reset or revert to the mean. This market has continually advanced at a pace well above the mean for an extended period of time with the exception of the first and second quarter of 2020.
Our goal is to evaluate opportunities, be aware of systemic risks and prepare to take action in an effort to protect our portfolios through risk mitigation while seeking income and growth appreciation by careful deployment of capital in markets that may become increasingly chaotic with the continued volatility we have seen over the past year.
Throughout 2019 we believed that the markets (and the FED) were complacent, and in our opinion, were in need of a reset. We felt it would be healthy if the market had a technical correction of -10% to -15% to take some of the froth (potential bubble) out of the market which could happen in first two quarters of 2020. Well that’s exactly what we received, however, it was due to a forced shut down of the economy. If the market corrects and then bounce back like it did, and can handle the FED’s adjustment to extreme lower interest rates and the massive amount of stimulus that was put into the system, then we believe that the foundation of a continued bull cycle will remain in place. So we remain cautiously bullish for the second half of 2020.
Markets move in cycles and now is a great time to plan for the next few years. These cycles repeat themselves and we believe the market has broken out of the 16-year secular bear market and is still within a secular bull phase. Even though the market had a violent 30% correction early in the year it appears to remain in longer-term secular bull market that may have many years of potentially positive results ahead. However, past secular bull periods have not been straight-up affairs and tend to have many pullback periods that can keep the trend confusing for investors, but in time can become more obvious once the business cycle and the economic backdrop improve. For now, we suspect that further gains in the market will continue to be met with a fair amount of skepticism and even pessimism which justifies the recent increase in volatility.
In front of the upcoming November election, the markets have the potential to shift into either a cyclical bull or bear phase that could change the direction of this secular trend. Our strategy is to position our portfolios properly to take advantage of the next cyclical change.
U.S. economic growth slowed in early 2020, pulled down by the covid-19 pandemic shutdown. Although strength in various covid-19 related sectors persists heading into the second half of 2020, we expect stabilization, and explosive overall growth next year. A myriad of uncertainties are clouding the outlook, including earnings and the presidential election. Ongoing trade war ambiguity could further depress corporate confidence and investment.
A key risk in 2020 is that manufacturing weakness and the reduction of business investment could hurt services activity and consumer spending, by depressing job growth from its 2019 peak. Although the U.S. unemployment rate (a lagging indicator) remains high, weekly initial jobless claims (a leading indicator) in has been rising. As such, U.S. payroll growth may continue to be muted if the return to normal within the US continues to stall.
We are into the early part of the second-quarter earnings reporting season and while the consensus for the S&P may be for a negative comparison to the same period last year, these lower expectations also create the backdrop for some positive surprises that could balance off the news into a muted and neutral market response.
The stock market has rallied back nicely from the low made in March. The Nasdaq has lead the way making new highs with the Dow lagging. We think this rally was fueled by managers “looking through” the negative news and focusing on 2021. Investors may be more optimistic but we believe the news of the world is not so positive, which makes recognizing changes in the overall tone that much more difficult. During that time frame the markets have built a base of consolidation as well as an upward trading range as represented by the blue shaded range. The resiliency of this market is unprecedented, however, cautious optimism is prudent at this time.
We will be watching the markets closely so that timing of a resumption of the bull market back to the highs remains in our favor relative to our cash position. We will keep you posted on our progress and strategy.
Volatility (VIX): Volatility, as measured by the VIX, is a statistical measure of the dispersion of returns for the S&P 500 index. Sometimes it’s important to remember that some of the biggest moves in a trend come at the end of a trend, and it may be best to watch how things unfold rather than succumbing to the “Fear of Missing Out” that often occurs after the market has made a strong move to the upside. We believe the recent pick-up in volatility, coupled with the derivative volatility measures referenced in the charts above and below, is a possible sign of a near-term trend. The recent strength in the averages paired with the recent drop in volatility, lends credence to our belief that the markets have a greater upside potential than the probability of making new lows.
Investor Sentiment: The chart above is one of the more compelling charts in this report. It compares the price-to-earnings ratio (P/E) for the Standard & Poor’s 500 Index with the 30 day average for the Chicago Board Options Exchange Volatility Index, or the VIX. As you can see in the charts, the indicator line has shifted dramatically over the first half of the year from the Complacency (overbought) range to the Skeptical (oversold) range. This further indicates overall strength in the perception of the markets in the face of extreme uncertainty. A continued rise in corporate valuations (P/E ratio) without a commensurate decline in volatility (VIX index) has kept the upward trend to this market enacted.
Investor Sentiment (AAII Bears vs Bulls): The American Association of Individual Investors is an organization that polls its members weekly on whether they believe the market will be up, down, or unchanged, six months in the future. This is a graph (above) showing the percentage of the members who gave a bullish response, measured with a 50-week moving average in red plotted against the S&P 500 in black.
Short term indicators related to investor sentiment appear to be showing “low levels” of bullishness which is a contrarian indicator that is fueling this market. Many short-term technical indicators are in overbought territory with the long-term trends remaining bullish. The bottom line to all this is that we expect to see the market continue to rise only if positive news begins to accelerate.
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Volatility: The chart above represents an overlay of the S&P 500 Index and the spread of the VIX spot (current) price minus the VIX 3 month futures price (as represented by the green and red shaded areas on the chart). It currently shows the VIX term structure at a discount and is known as “backwardation” (in red). The term structure when combined with the other volatility indicators can represent a near-term shift, reversal or continuation of a trend within the equity markets. What is currently at play is a probability of a continuation of the rally. We will be watching closely for signs of a reversal.
Equities: As mentioned in the discussion regarding volatility above, equities globally could still be in for a roller coaster ride. One thing for certain, passive investing in equities will not be rewarded anywhere near the value of a seasoned active money manager or advisor. Buy and hold strategies may get tossed out the window in favor of periodic, if not frequent, rotations of industry groups and individual stocks held within as the stock market’s gyrations occur with more frequency and greater amplitudes.
The reason to own equities as a substitute for the extremely low yield environment of debt instruments will become increasingly harder to justify due to the dramatic expected rise in the standard deviation of returns owning stocks. As a subclass within the equity space, the dividend stocks may cause the most concern in the months and years ahead due to that fact that this is a crowded trade. Buying stocks for “yield” while ignoring the fundamentals of the company’s balance sheet leverage and price multiples are sure to catch many investors off guard.
These dividend stocks are subject to even greater downside moves than the overall market primarily because they are, by subclass, over owned. This is notwithstanding the probability that the dividends are cut, if not eliminated for the especially high yielders (REITS, energy, utilities). If the yield curve shifts upward, these stocks will become less attractive and additional selling pressure will occur.
Earnings are expected to begin accelerating again late in 2020 and early 2021, but that expectation is partly predicated on a positive outcome with re-opening the country, a possible vaccine for covid-19 virus and a favorable outcome with the election. In addition, due to the effects of the shutdown, further profit margins could continue to come under pressure in 2020. The macroeconomic environment, including easier monetary policy and lending conditions, supported price-earnings (P/E) expansion in 2020 and 2021, but those effects need to be backed up by a strengthening economy. The wide gap between stock market performance and corporate after-tax profits suggests the latter needs to accelerate.
The overplayed trading style of consistently “buying the dips” (RED) was replaced in the first quarter with “sell the rallies” (BLUE). “What could go wrong” may be overshadowed with “I need to get out”. Complacency may yield to fear as volatility ratchets higher. This is exactly what we witnessed in the first quarter. However, we feel that this will revert back to “buying dips” in the second quarter of 2020.
There is a counterintuitive argument to make in favor of US equities specifically and in particular. This argument is in parallel with the tenet that the USD (US Dollar) will remain the global reserve currency. So long as the dollar remains preeminent and so long as the sovereign interest rate spreads favor the US treasuries, then dollar assets will be sought after for investors worldwide seeking a haven for their wealth and diversification from their homelands’ currency.
Coupling this “bid for USD’s” and the possible repatriation of trillions of dollars held in non-US banks if those monies have some form of tax amnesty for US multi-nationals; the most probable benefactor of a significant amount of those dollars would be invested into US equities.
Attractive Sectors during this Bull Cycle: Based on historical data with a low yield curve in place, the best sectors in new stage bull cycle are growth related sectors that are rewarded by continued economic expansion. Technology, Consumer Cyclicals, Health Care and Consumer Staples should be considered and over-weighted in the portfolio. Non-growth related (defensive sectors) such as Global Equities, Energy Stocks and Financials should be under-weighted in the portfolio.
The chart below highlights our basic framework of overweighted and underweighted sector allocations.
The Future of Interest Rates: This chart (below) reflects the historically low interest rates that has been reached again in the first half of the year. We feel that rates will stall or flatten here in the short-term and then begin to move higher late 2021. Typically, and again in a normalized yield curve structure, money that exits (leaves) bonds typically find its way into equities furthering a bullish strategy to own stocks. Again, the chart below shows just how low rates are relative to history.
The new highs in the stock market are capturing much attention of late while other areas of commodity prices and interest rates have been moving lower over the past month. It could be that the lower rate and inflation trends are helping to boost the stock market to some degree, but considering the already-low levels of these economic indicators, there might not be that much room for them to move substantially lower. However, the near-term downward trend should stabilize. The yield on the 10-year Treasury note has trended back to the technical support level of 0.73% which is probably at its bottom. The long-term trend should take it back into the range above 1.73%.
Energy: Global demand for oil has collapsed with the pandemic causing the price to fall to unprecedented level of $6.50 per barrel. However, when the panic stopped the price of oil rallied to a normalized range relative to demand at around $40 per barrel.
Watch oil closely as it resumes as an indicator of global demand and a return to global economic growth. We expect oil to trade in the $40 to $78 dollar range by the end of 2021.
Current Trading Update: Given the higher probability of the markets rallying from here, we are maintaining our current equity and cash allocation. Our main concern of being heavier in cash is that this market is currently news-driven and with a seemingly endless string of bad news, we feel that any good news such as resolution of Covid-19 (vaccine) or a favorable election could result in a sudden reflex rally similar to those we’ve already seen.
Short term (days to weeks) – Cautiously Bullish but extended. The major indexes have continued their rallies of the past three months into new high ground but as a result of the move are now in a technically overbought condition that makes it more likely a pullback or correction could develop soon. We would consider any pullback to be a normal move within the longer-term bullish trend and would also expect a pullback to be in the 5%–10% neighborhood with the possibility of a larger correction if the news warrants such a move. The measures of stock momentum, volatility, and short-term investor sentiment are largely positioned near the high end of the scale from which previous pullbacks have developed.
Intermediate term (weeks to months) – Bullish. The Dow Industrials and S&P 500 have broken out from their ranges of the past 18 months and we believe are now positioned for further upside potential in 2020. Other than normal pullbacks and corrections along the way, we see the possibility of continued new highs during the year with possibly more volatility and gains that may not be as great as they were in 2019. The various groups and sectors continue to send mixed messages regarding the market trend with this lack of confirmation being a possible indication of rotation between various areas of the market that could make for a choppier pattern for the markets going forward. However, we think the overall trend is positive, and we see any dips or pullbacks along the way as being opportunities to add to equity exposure.
Long term (months to years) – Bullish. The secular bull market that began in 2009 remains intact as it moves higher in a larger rising channel that is 25% wide. The major indexes are in the higher end of their channels which suggests to us that there could still be plenty of movement in both directions while remaining positive for the longer term. These secular bull markets tend to go on until the measures of stock valuation and investor sentiment are at much higher levels than they are today. These secular bull markets also track the trends in the economy and although some measures of economic growth are in positive trends, the overall trend continues to be in a slow but steady recovery which has allowed stock prices to do the same. A booming economy can lead to a boom-and-bust stock market, but that kind of scenario could still be years in the future.