There was virtually nowhere to hide in the month of September. From small caps to large caps, growth to value, U.S. to international, and even bonds: All in the red. Perhaps a pullback—and it was a modest one—should come as no surprise. Equities have risen with nigh an interruption since the market lows of March.
Well, you might have been surprised if you had first looked at economic indicators. September had a fair share of positive ones. The Institute of Supply Management (ISM) Manufacturing Purchasing Managers Index (PMI) was above 50—indicating expansion—for the fourth straight month. And, if you expected services to be left further behind in the uneven pandemic reopening you’d be wrong. The ISM Services PMI was above that critical 50 reading for the third straight month. And, the month closed out with a record jump in the U.S. Consumer Confidence Index.
So, did September’s pullback make sense? The pullback certainly made sense if you’re looking at corporate earnings, a COVID-19 “hot-spot.” Second quarter earnings for the S&P 500 were not much more than half of what they were in any quarter of 2019.
Source: Bloomberg. Past performance is no guarantee of future results.
Is there more downside to come? Consider this: The S&P 500 stands at roughly the same level as it was in the beginning of the COVID-19-driven decline. If the price was right at the beginning of the decline, and 2021 delivers a full recovery in corporate profitability, the conclusion is solid, though tepid: The market is currently valued fairly.
But the market is far from monolithic, especially right now. And while we may come to see the S&P 500 overall as fairly valued, some stocks may be quite cheap while others may be quite expensive. From the beginning of the S&P 500’s COVID-19-driven decline in February, the S&P 500 growth index is up over 10%, while the S&P Value Index has fallen more than 10%. The tech sector has of course performed even better, now nearly 15% higher. Growth and technology stocks are trading at premiums to the broader market not seen since just prior to the bursting of the tech bubble in 2000. These stocks may well be expensive.
If that’s the case, why not rotate to value stocks? While the market’s valuation may look right, the second condition—a full recovery of profitability in 2021—is far from a given. Value stocks have fared best in solid, straight-line recoveries. With political uncertainties and, most importantly, virus uncertainties likely to drive a saw-toothed recovery, the fundamental performance of value stocks may very well lag.
Fortunately, the dramatic run of growth and technology stocks has left other stocks behind as well. Many quality stocks, such as consistent dividend growers, are priced quite reasonably, and have demonstrated a greater level of resilience, with fundamentals that have historically been able to bounce back even with less than perfect economic backdrops. “Quality at a Reasonable Price” may make for a hard-to-pronounce acronym, but it may make for a solid investment choice in improving, but still uncertain, economic times.
All negative in September.
The S&P 500 flirted with a correction earlier in September before showing some resilience toward the end of the month to keep losses (-3.8%) fairly mild. Speaking of resilience, one notable development during September was the outperformance of historically resilient strategies like the S&P 500® Dividend Aristocrats®, which invest exclusively in companies that have raised their dividends for at least 25 consecutive years.
While not true every time, the Aristocrats typically outperform during market drawdowns, and the outperformance during September was a welcome development after performing roughly in line with the market during the drawdown from mid-February to late March. Nevertheless, the importance of focusing on companies that can sustain their dividends was on full display considering that dividend cutters in the S&P 500 have declined 32.5%, year-to-date through September 30, underperforming the market by a wide margin. Dividend raisers, on the other hand (+1.1%), have held up much better over that same period.
As we head into election (and earnings) season and with virus case counts on the rise in many parts of the country, many view this market as having some potential near-term vulnerability, but longer-term upside. Quality companies with strong fundamentals and stable earnings that fuel continuous dividend raises are, in our view, well positioned and continue to hold great appeal in that scenario.
Also notable from September’s market action was the underperformance of the technology sector. A central theme that has characterized the market of late—especially in the rebound—has been the wide divide between the winners and losers across market caps and investment styles. Technology stocks have, of course, been the biggest winners, but it’s important to remember that technology stocks still come in two basic flavors.
Because of the innovative nature of technology, there will always be a portion of the sector that is in earlier-stage or high-growth mode. Despite exciting prospects for future growth, these types of companies typically have less developed business models, and many have not yet managed to show profits. Currently, according to FactSet, roughly half of the stocks from the S&P 1500 Information Technology index fail to produce positive earnings.
In contrast, well-established technology names have more mature business models, providing investors with above-market growth rates and, rather quietly, a history of growing their dividends—a telltale sign of quality. How can investors isolate the quality technology stocks? One way is to focus on the S&P® Technology Dividend Aristocrats®, well-established, technology-related companies that have consistently raised their dividends for at least seven years.
Parabolic market performance over the last several years and increasingly stretched valuations have left many technology investors in a difficult position: Rotate away from the market’s strongest source of gains and be left with FOMO—or stay put and perhaps suffer if lofty valuations begin to roll over.
However, as a group, the S&P Technology Dividend Aristocrats have displayed hallmarks of quality, like stable earnings, solid fundamentals, and often strong histories of profit and growth. And on just about any metric, current valuations are well ahead of historic averages. Investors have options besides rotating into value stocks, and the ensuing risk of the value trap. Technology Dividend Aristocrats offer quality growth prospects, and a stable and growing dividend history at much more reasonable prices than the sector as a whole.
Source: FactSet as of 9/30/20.1
While equities approached correction territory toward the end of September, bonds did little to soften the blow for investors with balanced portfolios. The aggregate U.S. bond market was down 0.05%, while Treasuries eked out a positive return of just 0.14% for the month.2 Neither interest rates nor credit spreads moved much…so not much to see here in September.
It’s a question that some investors have been asking more frequently over the past couple of years. Historically, bonds have been appreciated for both their diversification benefits and the stability of the asset class’ income stream. But with interest rates so low, and the recent lack of support experienced during a down month in equities, some may be questioning if these benefits still exist. Specific to Treasuries, which have long been perceived as a safe haven for investors, a return of just 0.14% in September is likely to have been a disappointment. Recall, however, that just earlier this year when the S&P 500 fell more than 33%, Treasuries boasted positive returns of 5% from February 19 through March 23.
Last month we addressed how inflation expectations had been on the rise and some investors were looking to Treasury Inflation-Protected Securities (TIPS) for protection. This all came surrounding the news that the Federal Reserve Bank may allow inflation to rise past its long-term target of 2% prior to raising the Fed Funds Rate. While year-over-year inflation is likely to rise if we see a return to normalcy with respect to COVID-19 and a so-called “reopening” of the economy, this may already be priced into the markets. During the month of September, 10-year breakeven inflation expectations fell by 17 basis points (bps), indicating that a rise in inflation may have been over-anticipated. But even if inflation expectations don’t increase, rising interest rates, however, may still be in the cards.
Longer-term interest rates are typically more sensitive to the economic outlook, and even a saw-toothed economic recovery could very well be enough to push up longer term rates, at least modestly. Take a look at the often-referenced “2-10 spread.” Over the last 10 years, the spread between 2-year and 10-year Treasury yields has averaged 129 bps, going as high as 270 bps in 2011. That spread currently stands at just 56 bps as of September 30.
Source: ProShares, Bloomberg. 09/30/2010 to 09/30/2020
With little room for short term rates to fall, a normalization of the 2-10 spread would need to come from an increase in longer term rates. A bond portfolio that tilts toward shorter durations for treasuries and hedges interest rate risk in corporates may be an effective approach to mitigate the impact of a steepening yield curve.
1Price to Earnings is the ratio of the price of a stock (or index) versus earnings per share of the trailing 12-month period. Price to Cash Flow is the ratio of the price of a stock (or index) versus cash flow per share over the trailing 12-month period. Price to Sales is the ratio of the price of a stock (or index) versus sales per share over the trailing 12-month period. Price to Book Value is the ratio of the price of a stock (or index) versus book value per share. Book value is a measurement of total assets and represents the value of all assets if liquidated.
2Source: Bloomberg. Aggregate U.S. Bond market tracked by the Bloomberg Barlcays US Agg Bond Index, Treasury market tracked by the Bloomberg Barclays US Treasury Index.
Source for data and statistics: Bloomberg, FactSet
The different market segments represented in the chart use the following indexes: U.S. Large Cap: S&P 500 TR; U.S. Large Cap Growth: S&P 500 Growth TR; U.S. Large Cap Value: S&P 500 Value TR; U.S. Mid Cap: S&P Mid Cap TR; U.S. Small Cap: S&P U.S. 600 SC TR; International Developed Stocks: MSCI Daily TR NET EAFE; Emerging Markets Stocks: MSCI Daily TR Net Emerging Markets; Global Infrastructure: Dow Jones Brookfield Global Infrastructure Composite; Commodities: Bloomberg Commodity TR; U.S. Bonds: Bloomberg Barclays U.S. Aggregate; U.S. High Yield: Bloomberg Barclays Corporate High Yield; International Developed Bonds: Bloomberg Barclays Global Agg ex-USD; Emerging Market Bonds: DBIQ Emerging Markets USD Liquid Balanced.
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