Sept. 12, 2020
The reckoning is here.
When COVID-19 began its global spread in February and March, the S&P 500 fell 35 per cent in less than a month. It was the fastest-ever bear market – a decline of at least 20 per cent – as investors fretted over everything from lost jobs to disrupted supply chains to the prospect of widespread bankruptcies.
But then, an amazing recovery began in late March and kept going for five months, producing dazzling gains and sending U.S. indexes to record highs.
It was a perplexing rally. Dire news was everywhere, as countries shuttered businesses and enacted physical-distancing measures to combat the virus. The global economy staged an unprecedented drop, unemployment soared and corporate profits plunged. Governments scrambled to spend trillions of dollars to help the millions that had suddenly lost their jobs and couldn’t afford basic living expenses.
Market experts were amazed at the disconnect between the ebullient stock market and the dreadful backdrop against which it was occurring.
But the market’s resilience is now facing a major test. Many businesses have reopened; unemployment has fallen and consumer spending improved markedly. But recent signs suggest the economic rebound is levelling off and activity could take much longer than expected to return to normal. Coronavirus cases are on the rise across the globe, just as fall weather in North America and Europe threatens to accelerate the trend.
Stock market indexes, some sitting at record highs just 10 days ago, have turned wobbly, and the recent sell-off has shifted the market’s temperament. Volatility is returning, as months of smooth increases give way to the sort of violent swings witnessed during the stomach-churning sell-off early this year. Concerns about lofty valuations have moved to the forefront.
At the same time, many other issues could have a profound impact on a market that has largely tuned out concerns over the past several months as stocks marched higher. Besides an uncertain economic recovery, there’s the unclear future of financial assistance from governments and the potential impact of a messy U.S. presidential election in November.
Which raises the question: What should investors brace for next?
The market moves of the past several trading days are hardly as damaging as the full-on sell-off in February and March. Nonetheless, they are raising concerns about the stock market’s direction heading into the final stretch of 2020 and whether fast-charging technology stocks will sputter and fall.
The technology-heavy Nasdaq Composite Index, which notched a record high as recently as Sept. 2, slumped more than 10 per cent over the next three days of trading, marking its fastest correction since the bursting of the dot-com bubble in 2000.
The broader S&P 500 also touched a record high a little more than a week ago, then fell sharply. It ended the week down 6.9 per cent from its high.
Even Canada’s S&P/TSX Composite Index, a consistent laggard in recent years largely because of struggling energy stocks, recovered in late August to within 6 per cent of its February peak, before retreating 4.1 per cent.
Some experts warn investors should be prepared for more wild swings, given how far stocks have come in recent months.
“Right now, fundamentals suggest that valuations are extremely high, and pretty high relative to economic reality,” Kim Shannon, president and co-chief investment officer at Toronto-based Sionna Investment Managers, said in a phone interview. “There is a long path to recovery, and there is some destruction out there,” she added. "If small businesses are going under, it’s going to have a lingering impact.”
There is no shortage of grim economic figures to bolster bearish views.
U.S. gross domestic product, the value of the country’s goods and services, fell 31.7 per cent at an annualized pace in the second quarter, which was the worst performance in more than 70 years of record keeping.
Although the U.S. unemployment rate has been improving from a high of 14.7 per cent in April, it was a still-troubling 8.4 per cent in August amid additional layoff announcements. U.S. airlines, for example, have announced thousands of job cuts that haven’t shown up in the latest employment figures. “In many cases, these layoffs are expected to materialize in the fourth quarter, raising questions about the strength of the labour market recovery going forward,” economists at National Bank Financial said in a note.
To be sure, economic activity is coming back as businesses reopen after a lengthy lockdown. But it’s unclear just how long it will take to get back to where we were, and whether there will be setbacks along the way.
Making matters more complex, some observers are worried that the spectacular gains among flashy technology stocks – such as Alphabet Inc. (Google’s parent), Apple Inc., Amazon.com Inc., Facebook Inc., Microsoft Corp. and Netflix Inc. – has been driven by small investors turning to equity derivatives, known as call options, to magnify their gains if stock prices rise.
Amy Wu Silverman, an equity derivatives strategist at RBC Dominion Securities, monitored conversations on investing chat sites to get a sense of what was driving the speculative fervour that was upending typical market behaviour.
“These guys on sites are saying: ‘Hey, I bought this weekly call option and it’s up 7,000 per cent, so I’m going to buy more.’ There are lots and lots of these stories of people essentially using the stimulus money, more or less gambling, doing extremely well and just fuelling the fire by buying more calls,” Ms. Wu Silverman said in a phone call from New York.
Japan’s SoftBank Group Corp., a sophisticated investor, hopped in on the action, too, with trades tied to an estimated US$50-billion worth of stocks, potentially distorting markets even more.
By some measures, tech stocks now appear a bit nutty after initially attracting investors looking for businesses that could thrive during the lockdown. The combined value of Apple’s outstanding shares surpassed US$2-trillion in August, after the share price increased 60 per cent since the start of the year.
Tesla Inc., the electric car maker whose share price rose as much as 495 per cent this year, became the world’s most valuable car maker in July, passing Toyota Motor Corp.
Canada’s Shopify Inc., the e-commerce giant, saw its share price rise as much as 185 per cent this year. Even after a recent decline, the company, which has not generated a full year of profit, is more valuable than Royal Bank of Canada.
Heady valuations suggest that the stock market could be entering a phase when speculative bets are removed in a process that could take months, affecting even investors who never dabble in options.
“By December, we could very well see a more rational market. But to be fair, that could mean that the market is down a lot,” Ms. Wu Silverman said.
Concerns about an impending downturn may sound like a clear signal to walk away from the stock market. But predicting short-term market moves can bedevil even the savviest pros. Few could foresee the carnage of February and March, nor the rebounds that followed.
Canada’s biggest bank stocks, the bedrock of many investment portfolios because of their strong long-term performance and rising dividends, plunged an average of about 40 per cent in a matter of weeks out of fear that the global economy was on the brink of a depression.
Investors turned upbeat after extraordinary efforts by governments and central banks to keep the economy alive with low interest rates and benefit cheques. Yet it was still perplexing to see major indexes rally to record highs, implying that companies were in better shape during the pandemic than before it began.
There was a takeaway here: Most investors should do nothing when markets turn rocky. That is, maintaining your current holdings and tuning out the bad news eliminates the risk of selling your stocks when they’re down and missing the recovery.
Doing nothing could be the right approach now, too.
David Kostin, chief U.S. equity strategist at Goldman Sachs, recently ramped up his enthusiasm toward stocks. In mid-August, he raised his year-end target for the S&P 500 to 3,600, up sharply from his cautious target of 3,000 previously. The index closed on Friday at 3340.97.
Mr. Kostin thinks the index will rise even higher by mid-2021, to 3,800, as low bond yields continue to make stocks look attractive by comparison and corporate profits rebound by 30 per cent next year as the economy improves.
Embracing this approach suggests that any sell-off could be a buying opportunity.
Mr. Kostin is not even bothered by soaring tech stock valuations. In a note last week, he pointed out that the sector enjoys far stronger growth prospects than the broader market and is saddled with less debt, making it one of his top recommendations.
Other observers aren’t so sure how the bull market will continue, though – underscoring a cautious approach to their investing strategies.
A key concern is the unusual nature of the market run-up in recent months. A remarkably small number of stocks have soared since March, while most stocks are still meandering below their prepandemic highs, creating a lack of balance that may be unsustainable.
At the start of September, Apple, Microsoft, Amazon.com, Facebook and Alphabet were up an impressive 59 per cent year-to-date, as a group. But the other 495 stocks in the S&P 500 index were up a mere 1 per cent.
This small group of winners is making some investors nervous. The fear: The engines of the bull market recovery since March – those high-flying tech stocks – will sputter, leaving little appetite for stocks in other sectors. Apple, for example, fell 8 per cent on Sept. 3, rattling broader markets over the next two days. Tesla plunged more than 20 per cent in a single day.
“That was the perfect day to tell you that the market is priced to perfection because nothing happened. But people just wanted to sell,” Gajan Kulasingam, a portfolio manager at Toronto-based Goodwood Inc., said.
“I think that market participants are thinking that there is a V-shaped recovery in the stock market, driven by select industries and businesses. And now they are trying to say that there is a V-shaped recovery in the economy as well. But we would argue against that. I think that is completely misguided,” Mr. Kulasingam said.
Although second-quarter corporate financial results – the profits and losses that companies generated in April, May and June, when much of the global economic activity was still halted – were largely better than expected, some investors aren’t so sure the trend is sustainable.
“A lot of that was buoyed by massive cost-cutting, which of course is leading to very high unemployment. It may stay high, which is a big concern,” Stephen Takacsy, chief executive officer and chief investment officer at Lester Asset Management in Montreal, said.
There are other potential obstacles. Kevin McCreadie, CEO and chief investment officer at AGF Management, says he believes that investors have already accounted for a vaccine showing up – meaning that good news is already priced in to stocks. What isn’t priced in is the time it takes to roll out the vaccine, offering potential bumps if there are delays or setbacks.
As well, he is nursing concerns that have little to do with the pandemic. For example, he thinks the coming U.S. presidential election is a simmering risk for the stock market, especially if it doesn’t yield a clear, uncontested result.
“I think the election is the biggest thing that weighs on people. And that’s not just a U.S. event. If it’s a contested election, it will affect every market in the world,” Mr. McCreadie said.
This wall of gloom is not a justification for selling stocks. But it suggests that investors might want to prepare themselves for a potentially rough ride ahead.
A more upbeat view is that investors will move out of richly valued technology stocks and into cheaper stocks that are better geared toward a receding pandemic and recovering economy. If this happens, broad indexes may move sideways at relatively high levels as new winners emerge to replace previous winners.
“From here, the index may stall because the market rotates and broadens out,” Mr. McCreadie said.
He believes that can be particularly good for sectors such as financials: If loan losses come down and loan demand picks up as small businesses reopen, bank stocks should perform well.
Another factor working in favour of the stock market: Despite the dizzying number of concerns facing the market, there is a distinct lack of attractive alternatives. That could provide some support for stock prices.
Feel like hiding out in Guaranteed Investment Certificates? Though safe, GICs short-term are yielding less than 1 per cent right now.
Government bonds look similar: The yield on the 10-year Government of Canada bond is now just below 0.6 per cent, down from 1.7 per cent at the start of the year.
By comparison, stocks can deliver robust dividends that are relatively safe. Many Canadian banks, telecom stocks, real estate investment trusts, utilities and pipelines – though potentially vulnerable to any market sell-off – have dividend yields of 4 per cent or higher, rewarding long-term investors who can ride out a surge in volatility.
These stocks also happen to be well below their prepandemic highs. Indeed, Ms. Shannon expects that the Canadian stock market – filled with these less-than-glamorous dividend generators – is particularly attractive right now because it is cheap relative to the United States and much of the rest of the world.
“If there is going to be a pullback, it is not going to be as extreme in Canada. Canada is a defensive place to hide,” Ms. Shannon said.
Mr. Takacsy agrees that low interest rates make dividend stocks stand out as good opportunities in today’s low-interest-rate environment. He highlights renewable energy stocks, which have stronger growth prospects than traditional utilities. Energy infrastructure stocks, which operate as quasi-utilities, also have very attractive yields: Enbridge Inc.'s yield is 7.9 per cent and Keyera Corp.'s yield is 8 per cent.
Both Enbridge and Keyera are part of National Bank’s latest dividend all-stars list of Canadian stocks with sustainable payouts.
Mr. Kulasingam said that he’s looking for stocks that can perform well no matter which path the pandemic takes. Among two of his current holdings he believes fit the description: Polaris Infrastructure Inc., which owns a geothermal facility in Nicaragua; and Enghouse Systems Ltd., a software company.
One upbeat view is that investors will move out of richly valued technology stocks that were ideal during the lockdown and instead scoop up cheaper stocks that are better geared toward a receding pandemic and recovering economy. As a result, broad indexes may move sideways at relatively high levels as new winners emerge to replace previous winners.
“From here, the index may stall because the market rotates and broadens out,” Mr. McCreadie said.
But even stock pickers can see the value in holding more cash right now, as a cushion against downturns and spending ammunition if better buying opportunities arise.
Mr. Takacsy’s cash level is at 7 per cent and might go as high as 10 per cent, up from a normal level of less than 4 per cent. Mr. Kulasingam has raised his cash level to about 15 per cent of his fund’s assets, up from a normal level of 5 per cent or less.
“Rather than predict, I try to anticipate and prepare,” Mr. Kulasingam said. “A lot of times, people don’t plan. And when they don’t plan, they freeze when things happen and they don’t know what to do.”
Stock market volatility is on the rise – and understanding the challenges ahead is perhaps the best way to prepare for it.
This Globe and Mail article was legally licensed by AdvisorStream.