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Has The Market Come Too Far Too Fast?

| July 22, 2020
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What a year 2020 has been, and like no other in the history of the United
States. Pandemic struck forcing the government to close the economy
and push the United States into a recession. After a 34% stock market
decline in the matter of 27 days, the S&P 500 saw a robust rebound and
is now close to even for the year. Now, it is important to know that the S&P
500 Index is not the best reflection of the broad US stock market for a
couple of reasons. It is composed of the 500 largest corporations in the
US, as well as having a heavy weight to what people call the FAANG
stocks(Facebook, Alphabet, Apple, Netflix, and Google). Comparing the
equal weight index to the market weight index we find a year to date
performance that trails by around 10%.

Lately I’ve heard a lot in the financial news that there is a substantial
disconnect between the economy and the stock market. Financial
professionals believe this to be true due to the reasoning that the market
has rebounded over 40% from its lows while the economy, although
improving, is still showing recessionary numbers. Being analytical in
nature, I say let’s look at the underlying data. First of all, the stock market
is a leading economic indicator which tends to base its’ returns on
underlying fundamentals 12-18 months into the future. What market
participants have done is pretty much erase 2020 earnings and started
looking well into 2021. My second point is around the underlying sectors
and industries. The companies that are able to weather a quarantined
economy are prospering while those that aren’t, have beaten down stock
prices. For example, technology and consumer discretionary are positive
for the year while financials and energy are both down over twenty
percent.

This brings me to my next topic, whether technology is overvalued
compared to the rest of the market? Although this may be true on a trailing
twelve-month basis, I don’t believe this to be the case on the premise of
forward twelve-month earnings. Investors are willing to pay up for
technology companies because that is what has worked for past few
years, and many companies are actually benefiting from the work from
home environment. On the flipside value stocks have a fuzzy picture and
many industries look very expensive when projecting out their earnings
over the next 18 months. Nobody really knows when the world will go back
to normal, and when people will feel comfortable eating out or flying on an
airplane. I believe growth stocks will continue to outperform value until we
get a vaccine, and the economy shows strong signs of recovery. Although
I favor growth stocks over value, it is still important to be properly
diversified across both in order to participate in either scenario.

So where does the market go from here? It is my expectation that the
market will experience continued volatility for the rest of the year but will
finish around these levels. It will continually weight improving economic
data with increasing coronavirus cases. The market also has the added
threat of a full democratic sweep, which could add to potential downside
risk. I see the election as having a short-term effect since neither
candidate will be proposing a tax increase while the economy is still on
shaky grounds. Historically the market has achieved higher returns under
a democratic presidency, however it is not as important as having a mixed
house and senate. Although there are many risks surrounding the
economy and corporations over the next six months, I do not anticipate
substantial downside for two main reasons. The first reason revolves
around hope for additional government stimulus, and the second is the
eventual approval of a vaccine. The market knows a vaccine will come at
some point, and that will be like flipping an on switch for the world
economy.

Managed Account Allocation: In our managed accounts we have
increased our allocation to equities over the last three and a half months,
but still remain slightly overweight to fixed income. We have been very
deliberate with the types of companies we are buying, which is why more
individual stocks have been added to your portfolio then in the past. The
added fixed income exposure gives us additional flexibility to take
advantage of any pullbacks in the market. We have increased our fixed
income credit quality, as well as added to international equities(which still
remains underweight). Our view on international markets is that Europe is
likely to receive additional government stimulus and they appear to have a
better handle on the virus than we do.

If you have any questions about the market or would like to schedule a
virtual meeting, please reach out to our office.

We wish you and your families continued health and safety.

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