The recovery in equity and bond markets during the second quarter was almost as dramatic as the crash during the latter half of the first quarter.  Unprecedented monetary and fiscal stimulus programs coupled with numerous promises of Covid-19 vaccines, improved and available testing, antibody and treatment advances led to a sharp snapback in April.  The promise of additional stimulus as well as employment gains in May and June continued to lift the equity markets.  It appeared that social distancing, business actions, state mandates and other measures to slow the spread of the virus were working as June came around, but the staged reopening of the economy in many states has led to recent record infection rates nationwide with dramatic increases in large, highly populated states that were mostly spared in March and April.  Texas, Florida, California and Arizona have had record numbers of cases in the past few weeks which has led to reversals of some allowed openings of bars, restaurants and other public spaces.

U.S stocks, as they have for several years, outperformed (or underperformed less!) foreign stocks during the first half of the year.  Given that most of Asia and Europe seem to be faring better in combating the virus and are also the beneficiaries of their own governments’ stimulus programs, the valuation differential is becoming harder to justify.  The popular U.S. stock indices are market capitalization weighted, meaning trillion-dollar companies such as Apple, Microsoft, Amazon, and Alphabet (Google) that have performed very well this year have kept the indices afloat.  The S&P 500 “Equal Weight” index was down about 11% for the first half of 2020 while the S&P 500 index (market cap weighted) was down only 4%.  Given that the four aforementioned companies, together with Facebook, comprise over 20% of the S&P 500, while being only 1% (5 of 500) of the number of constituent companies, U.S. market outperformance for years has been largely attributable to these few tech companies.

Small capitalization and cyclical stocks led the second quarter rally, although year-to-date they still lag the WFM (work from home) technology and “essential” retailer stocks (Amazon, Walmart, Target, Kroger, etc…) which continued to climb and are solidly positive for 2020.  For the quarter ended June 30, 2020, the IWM (small cap index) and S&P Value Index were up 25.5% and 13.15%, respectively as compared to the S&P 500 Index which was up 20.0%.  While it has been painful to be a value investor recently, strategies such as value or growth tend to revert to the mean (eventually) and chasing high valuation growth stocks at this point in the cycle could prove unwise.

Hedging through index put options continued to be expensive given the continued elevated volatility, and as expected when markets rise, they are a drag on performance.  The hedging strategy acts as insurance, and when markets go up, the premiums continue to be paid while no claims are made.  Still, option hedging through index put options has been profitable for the first half of the year.

Corporate bonds gained meaningfully during the quarter as market participants expected continued low interest rates which the Federal Reserve confirmed will be the case at least through the end of 2021.  Additionally, the Fed announced it would be purchasing up to $250 billion in corporate debt in the open market through a program funded by the CARES Act.  Buyers for many investment grade corporate bond issues completely disappeared during the first quarter, but the Fed’s action brought them back.  Even though liquidity returned to the bond markets, companies will eventually have to pay back the loans, and many companies’ operations have been severely disrupted at least while the virus is infecting tens of thousands each day and possibly beyond.  While certain companies and industries have been and will continue to be impacted by the pandemic’s collateral damage, their bond issues trading at yields to maturity of under 3% doesn’t seem to compensate adequately for the risk of default or rising interest rates that may occur several years down the road before these bonds mature.  I do believe we will see better opportunities to invest in bonds in the future than we are seeing now.

“Inflation Protected” fixed income ETFs which will benefit if inflation increases seem to be an interesting alternative to government debt which are yielding historically low rates and corporate bonds which key off “risk-free” rates on government issued debt.  I believe that between the trillions in stimulus, supply chain disruptions and the costs of doing business in the Coronavirus era, inflation may arrive sooner than markets are currently pricing.  I didn’t even mention the federal deficit which now exceeds $26 trillion.  I know the government can print money whenever it needs, but is there a limit?  U.S. sovereign issues have been the safe haven during past crises and the dollar is the world’s reserve currency, but if we can’t get the virus under control and the deficit continues to spiral out of control, perhaps the unthinkable could happen.

While 2020 has been a rollercoaster with both huge health and economic crises as well as great social unrest in the wake of the high-profile and videotaped police killing of George Floyd and other racial minorities, the markets have proved to be quite resilient.  With all this and the presidential election looming, I believe there will be higher than normal volatility over the balance of 2020 and while I think the economy will rebound once the virus threat is under control, the market may already have discounted much of that rebound.  One key factor in considering the near-term direction of the market that may offset the many negatives of the continuing economic shutdowns is all the cash on the sidelines waiting to be invested.  Behavioral finance has proven that FOMO (fear of missing out) can play a huge role in extending market rallies.

I hope you and your loved ones are safe and healthy. If you have any questions about this commentary or anything else related to your financial life, my line is always open.

Best regards,

Steve