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State of the Markets

Wells Fargo Investment Institute - May 12, 2020

Darrell Cronk

Bear Necessities

by Darrell L. Cronk, President, Wells Fargo Investment Institute, Chief Investment Officer, Wells Fargo Wealth and Investment Management

“Truth is ever to be found in simplicity, and not in the multiplicity and confusion of things.” – Isaac Newton

Ever feel like down is up and up is down? It is not uncommon for this phase of a bear market to leave investors perplexed. Unusual, almost illogical patterns abound:

  • The worst economic data we likely will see in our lifetime appear to be shrugged off—or already anticipated — by markets.
  • Consumer confidence and spending plunge, millions lose their jobs at levels not witnessed since the Great Depression, and yet consumer stocks help lead the recent market recovery higher.
  • Corporate earnings guidance is being suspended at a torrid pace, offering few clues about the future, and yet levels of uncertainty and volatility continue to decline.
  • The largest federal budget deficits in history and an avalanche of U.S. Treasury issuance leave interest rates unaffected or trending even lower.
  • Municipal bond prices charge higher even as state and local governments plead for more assistance from Congress, their budgets strained like never before.

It is safe to say that investors feel like they are receiving confusing signals. Let’s try to make some sense of it by briefly expanding on three important points.

1. The pandemic has triggered an abrupt, deliberate stop to economic activity. There are two important ways to think about economic conditions. First is the absolute level of economic activity, which is unquestionably dismal by any account and measures how far current conditions are from their historical averages. Second, and more meaningful to the markets, is the momentum of activity, which measures how quickly conditions are changing in relation to recent levels. There are some early signs that a number of closely watched, high-frequency indicators are currently bottoming, including mortgage applications, gasoline sales, and passenger screenings at airports. This, coupled with most states beginning to reopen, has markets anticipating that key economic momentum may soon be turning higher. Since markets are forward looking and economic data are mostly backward looking, markets almost always advance higher before economic data improve. Easy reference points would include 2009’s strong equity performance prior to economic data actually bottoming, or further back when the stock market exhibited strong gains through both World War I and World War II.

2. A second frequently cited reason for disconnects includes the size and speed of monetary and fiscal stimulus provided during this recession. Indeed, the policy response has been forceful thus far, with around $2.8 trillion of stimulus on the fiscal front and a $2.4 trillion expansion of the Federal Reserve’s balance sheet. The breadth of measures taken by global central banks to maintain liquidity and flow of credit is also substantial, far exceeding initiatives taken during the 2008-2009 global financial crisis. Note that the four largest central bank balance sheets will surge to nearly 17% of GDP by year end—three times larger than the 6%-of-GDP level in the first year of financial crisis. This rapid acceleration in money supply creates a sort of liquidity boom, with money growth far exceeding GDP growth. This shot of liquidity helps backstop investor confidence and inflate financial asset prices. Bond markets have been a larger beneficiary of this backstop and liquidity, as credit spreads narrow, bond prices rise, and issuance of new debt occurs at record levels. And because equities are currently the highest yielding liquid asset, acceleration in liquidity provides for additional lift to equity multiples, as well. 

3. A third important variable within these disconnects has been distrust in the persistence of narrow equity breadth and leadership. Current equity market concentration is the highest in recent history with the five largest stocks accounting for 21% of the S&P 500 Index market capitalization—exceeding the prior high of 18% in March 2000. While the S&P 500 Index trades roughly 13% below its February 19 all-time high, the median stock trades at a more substantial 23% below its prior high. This 10-point difference between the index average and the median price is, by historical comparison, an unusually wide dispersion level. Among the leading groups are the same large-caps with strong balance sheets and secular growth prospects that had been outperforming before the coronavirus outbreak. This has given the appearance to many casual market observers that widespread recovery has been better than reality suggests, further creating degrees of separation between the most loved and the most despised groups. Information Technology roars while Financials struggle. Health Care strengthens while Industrials languish. Consumer Discretionary shines while Energy falters. For now, these trends look uninterruptable; however, history teaches us that narrow market breadth has eventually gotten resolved following a similar pattern, leading to large drawdowns as the handful of market leaders ultimately can’t sustain enough earnings strength to justify elevated valuations and investor crowding.

Recessions, bear markets, and credit cycles can be confusing and painful. This cycle will undoubtedly leave the kind of deep wounds that we cannot yet fully understand. We expect these wounds to heal, but it will take time. Governments help mend these wounds by providing needed programs and creating favorable conditions to blunt the ill effects of lack of liquidity and risk of insolvency. But even governments have their limits and cannot promise a return to profitability, confidence, and consumption. Following every major crisis since the Industrial Revolution, it has been entrepreneurs and companies that have led the way out by creating new business models, new technologies, and new health care breakthroughs. I see no reason why this time will prove any different.

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