Prior to the last few days, the saying that, “stocks always go up,” appeared to be gaining credence with the NASDAQ rallying an incredible 75.7% between March 23rd and September 2nd. However, gravity has once again reasserted itself and equity markets have been falling from their lofty heights. Although, as figure 1 below shows, we should keep things in perspective as the major U.S. indices are still approximately 50% higher than their March 23rd lows.
We do not know how widespread or deadly the coronavirus will prove to be, but the impact on markets has been significant (essentially wiping out of much of the gains of 2019). This is not surprising given that the sharp rally in late 2019 was prefaced on the notion of a stabilization and uptick in global growth (see figure 1).
Aside from speculation that the volatility was being driven by unusual activity in the options-market, we also acknowledge other risks. Congress has yet to agree upon another round of fiscal stimulus, the U.S. election is quickly approaching, U.S – China tensions may reignite, and the 10-year U.S. Treasury yield may challenge equities if it drifts higher as the economy improves. Each of these scenarios may lead to increased volatility in equity markets. It is also possible that Technology investors are growing concerned that vaccines could meaningfully challenge the “stay-at-home” narrative as consumers return to normalcy at a faster pace than expected (see figure 2).
In our view, the most likely culprit of the sell-off is what many investors would refer to as “froth” with sentiment getting ahead of fundamentals. Thanks to massive amounts of monetary and fiscal stimulus and a faster-than-expected economic recovery, financial markets have significantly outperformed during this recession. As figure 3 shows, the S&P 500 has averaged a return of about 34% in the 12 months following its trough (or bottom) during recessions. Thus far, the S&P has returned approximately 50% since March 23rd (recent losses are included). If these gains hold, this will be the best post-recession recovery outside of the Global Financial Crisis (when the S&P 500 rallied 69% in the 12 months following its trough).
|Periods of U.S. Recession||S&P 500 Drawdowns||S&P 500 Returns After Trough|
|Economic Peak||Economic Trough||Months of Contraction||S&P 500 Peak||S&P 500 Trough||% Decline||12 Months||18 Months||24 Months|
|Average Duration:||11 Months||Average (Decline / Gain):||-30.3%||34.3%||35.2%||42.4%|
Our strategy is to remain focused on the 12 to 18 month time horizon. It is our view that the U.S. economy will likely be in better shape one year from now with businesses continuing to reopen and learning to coexist with COVID-19. We would be more concerned about the recent sell-off if we were seeing signs of weakness in the U.S. economy. While one can point to pockets of weakness, real U.S. gross domestic product (GDP) continues to track at about 30% annualized in the third quarter of this year. This does not mark a return the economic picture in the fourth quarter of 2019, but it is a notable rebound. Citi’s proprietary economic surprise index is also indicating that U.S. economic data are still beating consensus expectations (see figure 3). The fourth quarter is unlikely to be as robust, but our economists are still expecting to see positive economic growth.
While markets “take the escalator up and the elevator down” we suspect that the downside will be limited with the Federal Reserve essentially backstopping markets with its “do no harm” policy. Since the Global Financial Crisis, the S&P 500 has never corrected more than 10% when the Fed is expanding its balance sheet. Corrections are a normal part of investing so a sell-off that crests 10% would not be entirely surprising given the strong run we have seen, but we think that the downside is probably limited.
We remain focused on opportunities in cyclical sectors like Industrials and also small- and mid-cap shares outside of the U.S. – particularly Europe. Citi’s target for the S&P 500 remains 3,300 for year-end and 3,600 for mid-year 2021, which presents modest upside from today’s levels.