by Scott Ronalds
It was a remarkable quarter for investors as stock markets rebounded sharply, bond prices rose higher, and overall confidence improved in spite of a pandemic that continues to rampage many parts of the world. Below is our Chief Investment Officer's (Tom Bradley) letter to clients from our Quarterly Report, in which Tom provides some further context and insights on the current environment.
If you’re confused, you’re not alone. I am too. The bounce back in stocks after the March selloff wasn’t a surprise, but the magnitude and power of it has been.
It doesn’t feel like a V-shaped market recovery (straight back up after the down) fits with the social and economic outlook. Nor does it make sense that consensus estimates for U.S. corporate profits in 2021 and 2022 show a quick recovery to levels above a very robust 2019.
When confused, we go back to our 3-part analytical framework: fundamentals, valuations, and investor sentiment.
Fundamentals is a catch-all for the economic factors that impact corporate profits (which drive markets). On this front, it’s become apparent that reopening the economy won’t be easy. Government support will come to an end (taxpayers can’t afford to maintain the current level of assistance) and there will be plenty of missteps. We won’t know the true state of the economy until the subsidy tap is turned off. Not until then will we know how families are doing and if businesses that are running far below capacity can afford their rent and loan payments.
I’m a big believer in the adaptability of human beings and organizations. The planet will adjust to the new normal quicker than most people think, but there’s no doubt the range of possible outcomes is still very wide.
Valuation, the price we pay for an asset, helps make sense of what we don’t understand on the fundamentals front, but there are crosscurrents here too. The bond market’s low yields are telling us there’s trouble ahead, as are large parts of the stock market. Stock prices for companies that are economically sensitive, involve the movement of goods and people, and/or are reliant on human contact, are far below their previous highs. Investors are taking the view that ‘things will never be the same’ and as a result, price-to-earnings multiples reflect a subdued recovery.
The ‘never the same’ scenario, however, has had the opposite effect on firms that did well during the lockdown. This select group, mostly technology based, have seen their profit expectations and valuations skyrocket. Here, investors are focusing on the positive end of the range.
The one valuation input that impacts all stocks is interest rates. Rates, which have been low for some time, have gone lower and are expected to stay there. This is important for stocks — lower rates translate into higher P/E multiples — and goes a long way to explaining the market’s recent rise.
Investor sentiment is the part of the framework that helps us act when expectations (fundamentals) and/or valuations are at extremes. How optimistic or fearful people are, is a useful contrarian indicator at times when investors are overwhelmingly bullish (or bearish). Indeed, when stocks were melting down in March, we were able to chin ourselves up to buy equities partly because the panic was palpable. The risks were in plain view.
Today, sentiment is just as confusing as the fundamentals. There’s a general belief that the future will be difficult (bearish), but there’s also a confident contingent of investors who are actively trading stocks and snapping up risky, high-yield bonds.
In your Steadyhand portfolio, we’re taking both views into account. As you’ll see in this report, we have stocks that are benefiting from the ‘never the same’ scenario and others that must prove themselves. We’re OK with this blend because we don’t believe it’s the time to act boldly based on one view of the world.
We encourage you to read the rest of our Q2 Report, where we provide more details on our specific strategies and what we've been doing in each of our funds.
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