Broker Check

The Market vs. Economy Conflict Continues

| October 19, 2020

The seemingly ongoing conflict between market and economic data rolls on.

In the first full week of October, the S&P 500 gained 3.84 percent, the Nasdaq composite gained 4.46 percent, the Dow Jones Industrial Average gained 3.3 percent, and the Russell 2000 Index gained 6.4 percent. Meanwhile, unemployment remains high as parts of Main Street suffer.

Knowing what we know about election years, how do we make sense of such a strong start prior to political results being known? One thing is certain, pundits and armchair quarterbacks alike have used this opportunity to air wide-ranging opinions.

If it seems “loud” to you right now, you’re not alone. This post will help make sense of things by parsing through the noise to provide a clearer picture of what’s really happening.

COVID-19 and Market Volatility

First and foremost, the most controversial news is about COVID-19. Most narratives center on how cases are either surging or improving (depending on whom you ask).

For an unbiased perspective, we’ve spent the year using The COVID Tracking Project for all our pandemic charts and data because it provides an unbiased perspective. The group’s “mission statement” – The public deserves the most complete data available about COVID-19 in the U.S. No official source is providing it, so we are. – and the fact that Johns Hopkins University uses the data attest to its credibility.

The charts below, as of October 1, show increases in testing, cases, and hospitalizations. But they also show a distinct downward trend of COVID-19 deaths:

After a difficult summer, average metrics for August and September showed drops across the board at a national level. Even as indicators show a few states have rising cases over the last few weeks, it stands to reason that the market is encouraged by the countertrend of lower daily deaths relative to rising cases, testing, and hospitalizations.

The market seems to be buying into the notion that one or more COVID-19 vaccines with Federal Drug Administration approval are on the way. Also, the real-time science of treating infected patients has rapidly advanced to the point a greater number of infected people are surviving, which seems to be further buoying markets.

More survivors create less uncertainty and volatility. This is exemplified by the VIX Index, a measure of market volatility (more volatility = higher VIX value), taking out the September lows, even with the most contentious election in recent memory just a few weeks away:

As a result, it’s reasonable to assume “big money” institutional investors are beginning to like what they see from a volatility standpoint and from mortality rates associated with COVID-19.

Revenue and Profit Growth (And Actual Forward Guidance?)

Economy-wide corporate profits peaked in the fourth quarter of 2019, but then fell 12 percent in the first quarter this year and dropped another 10.3 percent in the second quarter. Profits declined at a 37.6-percent annualized rate in the first half of 2020, while real gross domestic product dropped 19.2 percent over the same time.

In other words, profits fell faster than the overall economy. However, we’ve identified three reasons to expect this process to reverse in the third quarter. In fact, evidence suggest it’s already happening.

First, it’s normal for profits to grow faster than the economy in early stages of economic recoveries. Past instances of this can be seen in the 2001 and 2007-09 recessions.

Second, the labor share of GDP – wages, salaries, and fringe benefits – surged in the first half of the year as firms reduced payroll rapidly, but not as fast as production fell. That means there should be less of an increase in payroll costs as the economy heals.

Lastly, many firms trimmed costs beyond payrolls, which further boosts profits. Think about the vastly reduced amounts of corporate travel and office space – it all helps fatten the bottom line.

All these items lead bottom-up forecasters to predict record profits next year for corporations overall. As such, there is a sharp upturn in earnings growth expectations in the year ahead:

Perhaps most remarkable is the expectation of 13.7 percent revenue growth less than a year from now. Companies can manufacture positive earnings, but not sustained sales growth, and it seems the market is buying into this data.

We can see this already beginning to show in real life as investors peak around the corner to see how third quarter earnings are shaping up. Already, an impressive number of firms have announced quarterly earnings per share gains north of 20 percent:

This continues what was one of the strongest quarters regarding earnings surprises. And the third quarter is already shaping up to provide more upside surprises. More amazingly, we’re starting to get more forward-looking projections from companies during earnings announcements, which is a welcome reversion back to the norm.

“Big Money” Moves

Our trusty Big Money Index from Map Signals shows more buying. At the same time, current events seem to be frontrunning historical data based on the well-documented BMI patterns during election years. So, we need to trust the ongoing BMI data in order to remain emotionless.

Early October BMI data show buyers are back earlier than normal in an election year:

Even with the uptick in the BMI, we need to point out the differences between “buying,” and true “big money” BUYING. The latter is exemplified by cyclical rotation that includes “unloved” equities and it’s what we’re starting to see now.

Institutional investors are buying in technology, discretionary, financials, industrials, healthcare, and even utilities:

Interestingly, energy stocks, which have long been undesirable among institutional investors, are not seeing sell signals. While there aren’t buy signals, the absence of sell signals in the most hated sector of the past year is itself a bullish indicator.

The seismic shift in buying is clear in the data from the last couple weeks, and it’s not defensive buying. Rather, “big money” investors are playing offense, jumping into juicier names and sectors, as the below table of the biggest 20 buys in the last week shows. More than half of the purchased stocks are in the technology and discretionary sectors:

The picture that’s emerging shows a few things.

For one, it shows buyers are back and diving into top-quality equities. It also shows how investors are playing offense, positioning themselves for wins, not playing defense to hedge losses.

The emerging situation also illustrates how election uncertainty is playing less of a role. While not knowing which way the election will unfold, it seems “big money” is confident a result will occur when expected.

Finally, this earnings season shopping spree shows us that firms are producing appealing profits. Based on the buys, clearly institutional investors expect that to continue.

As buying seems to be coming early this year, it’s another reminder that attempting to time the market is a fool’s errand. That’s why we took the opportunity to strategically rebalance our model portfolios at the beginning of this month, deploying the remainder of our cash.

We know there will be bumps in market in the fourth quarter. But we also know there is no way to time it perfectly to achieve maximum benefit and avoid all possible pitfalls. That’s why we follow rules-based principles, rebalancing quarterly to stick with our strategic plans, regardless of market conditions.

Securities sold through CoreCap Investments, LLC.  Advisory services offered by CoreCap Advisors, LLC. Cornerstone Financial Services, CoreCap Investments, and CoreCap Advisors are separate and unaf´Čüliated entities.