Markets continued to rally off their lows in May with the S&P 500 (in CAD) and TSX adding 3.85% and 3.04% respectively for the month. Although most markets still remain well off the highs set in February, we have now had two consecutive months of positive returns. To many, this may not seem to make sense. How can the market be rebounding while there is still so much uncertainty surrounding the re-opening of economies and the COVID-19 virus? Perhaps a look at central bank activities can provide some clues.
It can be difficult in hindsight to remember how uncertain things were just three months ago. With COVID-19 spreading, lockdowns being implemented, and millions starting to lose their jobs, central banks and governments sprang into action. Governments globally announced extensive support programs for businesses and consumers to bridge them through the economic uncertainty. Central banks focused on supporting the capital market by standing ready to supply an unprecedented level of liquidity to the markets, mostly through their ability to print money via purchases of publicly traded securities.
As is usually the case in a crisis, investors looked to the U.S. and its central bank, the U.S. Federal Reserve (the Fed), for guidance and reassurance. The chart below (Figure 1: Federal Reserve’s Alphabetti spaghetti of emergency measures) shows the host of emergency measures introduced by the Fed, but two stick out as being truly unprecedented.
- On March 23, for the first time ever, the Fed announced that it would begin to purchase investment grade corporate bonds.
- Then, on April 9, the Fed included high yield and municipal bonds.
Figure 1: The Federal Reserve’s Alphabetti Spaghetti of Emergency Measures
Facilities bolded were also used in 2008
MMLF, CPFF, and PDCF do not have program limits
Data as of May 27, 2020, accounts for Treasury backstop adjustment
*Includes Main Street New Loan Facility (MSNLF), Main Street Priority Loan Facility (MSPLF) and Main Street Expanded Loan Facility (MSELF)
**Includes Primary Market Corporate Credit Facility (PMCCF) and Secondary Market Corporate Credit Facility (SMCCF)
Source: U.S. Federal Reserve
A significant portion (96%) of the extraordinary measures committed by the Fed remain untapped. However, the sustained rhetoric of supporting the market by any means necessary was enough to have a stabilizing effect on the financial markets. As the research firm Cornerstone Macro put it, “What the Fed says matters as much, if not more, than what the Fed does.” The bond market has rallied and the sentiment in the stock market has changed from fear to “fear of missing out” (FOMO). Since its March lows, the S&P 500 has rallied by 36%.
While the move in global stock markets off their lows has been strong, it has also been exceptionally narrow. Many individual stocks have been left behind. The chart below (Figure 2: Concentrated Returns) shows the sector returns of the U.S. market (S&P 500 in CAD) and the Canadian market (S&P/TSX Composite) on a year-to-date basis. The only sector that has performed well in both the U.S. and Canadian markets is Information Technology. In Canada, the Materials sector has also performed well due to its high weighting in gold stocks, which tend to outperform during uncertain times.
Figure 2: Concentrated Returns
The outperformance of technology stocks was a key driver of the historic bull market that ended in February and has intensified as the market has fallen. The top five stocks in the S&P 500 (Facebook, Apple, Amazon, Microsoft, and Google) now account for 22% of the index’s total market cap. This level of concentration exceeds even the dot-com bubble era at the turn of the century when Cisco, Microsoft, GE, Intel and Exxon had an 18% representation.
In a COVID-19 world where physical services, such as brick-and-mortar retail stores, are unavailable or significantly limited, the trend to online has only accelerated. Additionally, the acceleration of working from home due to physical distancing measures has vastly increased the need for types of services technology companies provide such as online meeting software.
With a nod to the usual caveat about historical performance not necessarily forecasting future performance, historically we have seen a number of cases where a narrow market has preceded a significant market correction (for example, the Nifty 50 in the 1970s and the dot-com bubble in 2000). We also note that these are truly unusual times with extraordinary fiscal and monetary policies, changing work patterns, and changing consumer behavior. Will the current market narrowness follow historical precedent or will it be different this time?
We do not know the answer to that question, and do not feel that anyone has the answer. As such, we continue to focus on what we can control. Our focus remains on well-diversified portfolios that are resilient in good times and in bad times. That means investing in many sectors of the market and in companies whose valuations appropriately reflect their growth. While we do own some of the largest companies that are benefitting from the current trends, such as Google and Microsoft, we also see great value in some of the stocks and sectors that have been left behind.
In a narrow market, it can take only a few stocks to correct for an index to fall dramatically. The dot-com bubble is a perfect example of this. By owning a diversified portfolio that looks different than the index, we can spread out our risk and limit the possible impact of a few high flyers falling to earth.