U.S. stocks had a blockbuster second-quarter. Indeed, both the Dow and S&P 500 have posted their best returns in decades. How long can this outperformance last? With market sentiment still generally positive, some investors are asking whether supportive central bank policies and hope for a rapid economic recovery may be the set up for a third-quarter market surge.
We believe that the dominant narrative that had supported the second-quarter rally is increasingly coming under pressure. Stretched asset valuations and a historical precedent for weaker market returns argue for more caution in the coming quarter. As a result, we recommend that investors use recent market strength to reduce investment risk and raise cash through portfolio rebalancing.
Stocks Had a Stellar Second Quarter – What are the Chances of a Repeat?
Last quarter’s rally came on the heels of a sharp market pullback. Efforts to flatten the curve in March led to a massive experiment that had not been tried in well over a century: shut down the economy to curb a pandemic.
Risk assets experienced a sharp selloff in the first quarter on the prospect of weaker economic growth but regained their footing at the start of the second quarter. The rally arguably was fueled by a hope that massive fiscal and monetary stimulus efforts could contribute to a rapid economic rebound.
For example, Congress and the Federal Reserve responded to ballooning unemployment and economic uncertainties by launching unprecedented stimulus programs. On the fiscal side, several million businesses in the US received financial support through the Paycheck Protection Program (PPP). The government also issued cash handouts to unemployed workers and households alike.
At the same time, the Fed ramped up purchases of government bonds and mortgage-backed securities. The central bank also launched its Main Street Lending Program to make it easier for small businesses to borrow money. In late June, the Fed began purchasing private firms’ bonds through its Secondary Market Corporate Credit Facility (SMCCF). In a matter of weeks, the Fed increased its balance sheet by well over two trillion dollars – a feat that had taken years to accomplish during the Great Recession.
The critical takeaway here is that the second quarter market rally was built upon low price levels and expectations that policy efforts could support a rapid rebound in economic growth. This narrative, however, is increasingly coming into question.
History Suggests Softer Performance
Another important point to consider is that there is little historical precedent for a repeat of second-quarter market performance. We know this because we analyzed data to determine how markets have performed historically following a sizeable rally. Our work suggests that the return on the S&P 500 index in the third quarter could be less than half the 20% realized in the second quarter.
For example, history shows that the S&P 500 rallied 15% in the three months following market lows set in March 2009. How did the index perform in the next quarter? Well, the index gained only 5.5% in the next quarter. And this observation is not limited to just one period in time.
Looking at a distribution of returns going back to 1930, we find that market returns tend to come in between 0-10% in the quarter following a strong market rally at about two-thirds of the time. To be sure, the data showed that market performance on the heels of a massive rally was not only softer in the next quarter, but they were also consistently weaker 98% of the time.
The crucial takeaway here is that, from a historical perspective, strong returns do not beget even higher returns. While the historical data suggest that performance is quite likely to remain positive in the third quarter, from a purely statistical perspective, it’s hard to make a case that we’ll see even higher returns in the months ahead.
Unmitigated Healthcare Crisis
Finally, it’s important to note that the healthcare crisis is not improving, and this will challenge the market’s rapid recovery narrative. At the onset of the outbreak, there was a notion that if we locked down the economy and reopened in a deliberate, intentional way (think phase red, yellow, green), we’d be able to contain the coronavirus outbreak, and quickly have life get back to normal.
After initial success in flattening the curve, we’re now seeing that COVID19 cases are reaccelerating weeks after much of the US economy has reopened. With vaccine trials still ongoing, and infection rates currently on the rise, there’s a real risk that we may end up with a healthcare crisis more severe than the one we had in March.
Such an outcome could lead to delayed household spending and employer hiring decisions, challenging the dominant market narrative that supported second-quarter market performance. Indeed, with more state governors reversing or delaying plans to open their economies, it is becoming increasingly difficult to make a case that markets can continue to rally on hope of a sudden economic recovery.
What Should Investors be Mindful of Heading into the Third Quarter?
Investors should be mindful of the fact that expectations for the future often drive market behavior. Presently, there are arguably two vital expectations supporting market sentiment: 1) policy response will fuel economic growth, and 2) economic growth will quickly recover. Right now, it’s unclear whether monetary policy can do more than stabilize economic conditions.
Monetary Policy is not a Panacea
Monetary policy can only do so much to support economic growth. With that said, there is little doubt whether the Fed will pull out all the stops to stabilize growth. The Fed’s willingness to support its full employment and inflation mandates is evident in the various programs mentioned earlier. Even so, monetary policy is not a panacea for market-related concerns.
Take, for instance, the Bank of Japan. This central bank has been buying public and private sector stocks, bonds, and real estate for years. It has implemented non-traditional measures such as a negative interest rate policy and yield curve control. Japan’s economic growth has nevertheless been weak, and the performance of its markets has lagged its peers. A similar situation is present in the Eurozone.
Anecdotally, history has shown that markets tend to stage an early rally based on expectations of a massive game-changing catalyst, like an election, a rise in government spending, or a favorable change in monetary policy. Today, such expectations are playing out in mantras like “don’t fight the Fed.” Even so, what we’ve observed over the past couple of decades is that such rallies tend to wane as market participants eventually reset their expectations to the reality that policy alone does not heal what’s ailing a struggling economy.
Economy stabilizing, growth likely to struggle
Another issue with which investors must contend in the coming quarter is that weaker growth will challenge market sentiment. While some data have improved, reports are not yet consistent with a robust economic rebound. To this point, the IMF recently downgraded its estimate of a US economic recession from -5% set in April to -8% (consistent with the Great Recession) in June.
This view does not dismiss the fact that by some measures, the economy is stabilizing. Our own consumer and business diffusion indices show that US economic activity is recovering from lows set in April. Even so, these backward-looking indicators need to be reconciled with forward-looking realities: households are increasingly likely to curb spending amid the ongoing healthcare crisis.
A rising number of states are reporting record one-day coronavirus infection rates. The effect of which has led some governors to postpone reopening their economies and others to shut down establishments like bars and restaurants. Prolonging the economic lockdown may curb the recent consumer spending recovery.
Compounding the problem of lower consumption is the fact that individuals willing and able to spend are finding it harder to borrow money. This issue is evidenced in the Fed’s recent Senior Loan Officer Survey. It shows that banks are less willing to lend and that they are also raising lending standards. The implication is that individuals ready to spend, especially on big-ticket items like homes and cars, may find it increasingly difficult to obtain the loan necessary to complete their purchase.
Indeed, there’s no question that the US economy is showing signs of having stabilized. Nevertheless, the ongoing healthcare crisis likely will alter household spending behavior and challenge market expectations of a quick economic recovery.
How should investors prepare for lower returns and ongoing uncertainties in the third quarter?
It’s important to note that the second quarter rally has led to risk assets becoming expensive when measured by various valuation metrics. The combination of high asset prices and an unmitigated healthcare crisis may contribute to higher market volatility in the months ahead. In anticipation of a market pullback and increased volatility, we suggest that investors pare back recent gains to achieve two ends.
First, during this time of uncertainty, investors need to manage risk and ensure that their portfolios align with their long-term goals. Periods of market strength like we experienced in the second quarter can lead to portfolio drift. Therefore, we suggest that investors use recent market strength to trim winning positions and add to under-allocated holdings. This can be accomplished through portfolio rebalancing that realigns investment holdings with long-term target asset allocations.
Second, we recommend that investors prepare to use market volatility as an opportunity to raise cash. Periods of heightened market volatility may lead to selling assets at inopportune times. This is especially important given the tenable economic environment and ever present need to address unplanned life events. Therefore, we recommend that investors use this period of market strength to bring their portfolios back into alignment with long-term goals through rebalancing while at the same time setting aside some cash to meet unexpected needs.