We've seen a nice rebound from the March 23rd lows in the stock market, which has offered some reprieve from an unprecedented onslaught of bad news. Meanwhile, the nasty unemployment figures and damage to economy is becoming more clear with each passing week.
Some may even say "How is the stock market not still down further, considering the bad news?"
That would be an understandable question.
You see, the current stock market climate is seeing a huge differential between a few companies that are doing great (mostly big tech companies and a couple retail giants), and everything else that's really struggling. This email takes a quick look at the connectedness between the dire situation of the economy and "The Market."
But before I get into that, I have an observation, and to highlight this observation, let's dial back the clock to another period where there was huge outperformance by certain parts of the market...
In 1998, US Large Growth Stocks (companies trading at a high stock price relative to their earnings) were up 38.71%.
Meanwhile, US Large Value Stocks (those trading at a low price relative to earnings) were up just 15.63%.
In 1999, US Large Growth Stocks were up 33.16%.
US Large Value Stocks were up just 7.35%.
In 2000, the tech bubble exploded and these growth companies fell precipitously.
Over the next three years, US Large Growth Stocks lost 22.42% (2000), 20.42% (2001), and 27.88% (2002).
Value Stocks over those three years had a 7.01% gain, a 5.59% loss, and then a 15.52% loss, respectively.
For just a second, let's consider a hypothetical $100 investment into both growth and value stocks over those 5 years leading up to and during the Tech Bubble:
$100 invested into Growth Stocks in 1998 = $82.24 at the end of 2002
$100 invested into Value Stocks in 1998 = $105.94 at the end of 2002.
Despite underperforming in the two years prior to the tech bubble's burst, value stocks did not rise to unsustainable levels in the same way that internet-led euphoria drove growth stocks up. Less euphoria = less distance to fall when the crash occurred.
*Remember, this is totally hypothetical and not a real investment. I was 15 years old in 1998, so clearly this isn't a claim of my own past performance ;)
I highlight this example because the current divergence between growth and value stocks has not been this large since 1999.
The graphic below shows the difference in valuation between Value and Growth. I've circled the valuation of growth stocks both today and at the end of the 90s.
Anytime the conditions we're in start to mirror a historical crash, it merits our focus. That 'Growth vs. Value' relationship is consuming a lot of my attention right now as a portfolio manager, so expect to keep hearing about that from me for a while... But let's move on for now.
Now let's talk about "the market."
In the chart below, there are three lines showing YTD performance of the stock market:
Purple, which shows the Dow Jones Industrial Average
Blue, which shows the S&P 500 Index.
Green, which shows the NASDAQ Index.
These are the three major US stock indices that everyone tracks.... Notice how different each of these three lines are despite the fact that they're all invested in US Stocks.
Clearly, that's a lot of divergence between the best performing US stocks (those in the Growth-Heavy NASDAQ index) and the rest of the market.
So why have all stock prices not fallen despite a very challenging environment?
The answer is twofold:
(1) only a part of "the market" is represented in these three most popular indices, and
(2) prices = expectations
That's right, prices equal expectations of what the future holds.
With an accommodative Federal Reserve and an economy that had previously been very strong, the expectation is that the economy should bounce back --and today's prices reflect thatexpectation along with all of what we know about the damage COVID-19 has done to our economy.
So, in some respects, the market has recovered more than one might think. Yet, there's more to explore here.
For a second, let's just focus on the S&P 500...
The S&P 500 is about 505 stocks --all large stocks and all U.S. stocks. While these are the most watched stocks, they behave very differently than other parts of the market.
Large U.S. stocks benefit from the fact that big companies are often the beneficiaries of small companies struggling or going out of business. Thus, the solid rebound we've seen in that index.
If your local taco shop, burger joint, or family restaurant fails, where do you think people will go?
Here's a guess: Chipotle, McDonalds and Applebees (or big chain restaurants like these).
What about when local retailers fail? Where will people go?
Another guess: Costco, Wal-Mart and Amazon.
In fact, US Large Growth Stocks were actually positive2% through 4/30/20(!).
Let's look at the rest of the market (through 4/30/20):
Small US stocks were down 21.6%.
Large US stocks were down 7.2%.
Small Value stocks were down 30.4%(!).
Large Value stocks were down 17.0%.
Airlines are still down more than 60%.
Hotels down more than 50%.
Movies theaters and live entertainment (concerts etc.) haven't recovered.
Energy stocks have been crushed.
International stocks have been hit hard.
... Consider the chart below from Morningstar (through 4/30/20). The bold YTD column shows how bad it still is for most of The Market, while US growth is the only bright spot.
Clearly there's still A LOT of pain as a result of this crisis, and the performance of a few companies has driven the market back up from its lows in March, while the overwhelming tone amongst most companies is still dire.
We tend to look at just the largest US companies to gauge the connectedness of the economy to The Market, but the reality is that the market is much broader than just those companies. The Market covers big companies and small companies. It covers U.S. companies and international companies. It covers all sorts of sectors that are reacting differently, and for good reasons.
The Market is connected to where it thinks the economy is going and different parts of the market are connected to where they think different parts of the economy are going.
So here's the question everyone wants to know:
Where do I invest going forward?
I believe it's reasonable to expect that stocks with lower prices relative to fundamentals (like how much they earn) should have higher expected returns. This is the definition of a "value stock." But we know that there are periods of underperformance of anything we think will be worth more down the road and that nothing always wins. On the other hand, it also makes sense that companies with less earnings and high share prices (i.e. Growth Stocks) can borrow in today's low interest rate environment and continue to focus on growth, which is the bullish case for growth stocks.
We're going on more than a decade of value stocks lagging, and we haven't seen this level of growth stocks beating value stocks since 1999-2000 when pre-revenue internet companies were taking advantage of the tech bubble mania.
To me, that presents risk. Not so much risk that investors should abandon large US growth stocks, but just enough risk to warrant a deeper analysis of the kinds of companies they own.
As always, what YOU should invest in is reliant on what's going on in your life, what you want to accomplish, what resources you have to accomplish those things, and how much risk you're willing to adopt in pursuit of what you want to accomplish...
To discuss these specifics, I'll be reaching out to every client individually this week. Non-clients can book a quick investing discussion by following this link or by replying to this email.
Adam Harding, CFP
As always, this email isn't investment advice and it is for informational purposes only. It's just a guy writing some thoughts about the market that hopefully shines a light on some things worth exploring or asking your financial advisor about. Past performance is not indicative of future results.
Data Sources: DFA, Yahoo Finance, Morningstar.
Divergence in the Stock Market
May 17, 2020