The SPX peaked on February 19 which feels like a lifetime ago. The peak to trough decline of 34% was one of the most violent equity sell-offs in history. The 25% bounce from the low was also one of the biggest rallies recorded. Investors understandably feel whipsawed by the volatility. Many weren’t prepared for such a rapid sell-off and as risk premiums increased to record levels near the end of March, the US and other countries launched unprecedented stimulus programs to counter the negative economic effects of the pandemic. Below are key investment themes to consider to help you navigate the current market environment. 

Has the equity market already bottomed? 

The arguments for a prolonged bear market are self-evident. The shelter-at-home policies in the US and developed world will continue for the foreseeable future. Even though new COVID-19 cases are slowing, it’s unclear how the government can effectively reopen the economy without a second wave of infections, a scenario that might be happening in Singapore. Unemployment is projected to increase to 13%, and business confidence and spending will remain muted given the economic uncertainty. Historically, bear markets last many quarters and V-shaped recoveries are rare.

The bullish take starts with the fact that the health emergency is improving, albeit slowly. In the US, new COVID-19 cases are growing at a 5-day growth rate of 50%, down from about 100% at the start of April. Urgent efforts to develop a vaccine are underway with optimistic projections aiming for September. Anti-viral treatments have shown efficacy to treat patients even though broader tests are needed to confirm the tentative positive data. President Trump signed an order on Saturday requiring insurance companies to cover COVID immunity tests which should help broaden testing.

The growth rate of coronavirus cases in the US is slowing

US coronavirus cases and growth rate, 1-day change and 5-day change
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Though risk premiums have declined from peak levels in March, indicators such as VIX are still elevated relative to history. This suggests the market is pricing significant deterioration of fundamentals over the next few quarters. A further VIX decline to a more normalized level of 20-30 would coincide with higher equity prices. 

An important bullish consideration is the magnitude of government actions, which are significantly more aggressive than anything implemented in prior recessions. The emergency measures from 2008/2009 were not only swiftly activated in March but the scope was significantly expanded through nine lending programs totaling $2.3T (about 10% of GDP). The Fed also indicated last Thursday that it may purchase bond ETFs or junk-rated debt in the future. Meanwhile, the Fed’s balance sheet has increased by 50% to $6 trillion thus far, and $30 billion of Treasuries are purchased daily through quantitative easing (QE).  

The final bull argument is that equities typically bottom 3-6 months before a recession ends. In a bear market, market prices move based on the 2nd derivative of fundamentals and anticipate a bottom well before it occurs.

S&P 500 historically bottomed 3-6 months before the end of a recession.
S&P 500 SPX bottoms before the recession ends
Source: Anatomy of a Recession Presentation – Legg Mason

Decomposing the recent equity rally

The 25% SPX bounce from the March 23 low is largely explained by the containment of tail risk after the stimulus bazooka unleashed by the US government. Through existing and new facilities, the Fed effectively put a ceiling on risk premiums and committed to injecting unlimited liquidity to unfreeze the dysfunctioning credit market. As a result of the Fed action, VIX declined from 83 to 42, and HY spreads compressed to 557 bps from a peak of 837 bps. 

Risk premium measures such as VIX and HY spreads remain elevated relative to history. Other risk barometers such as the Ted spread, currently at 129 bps, remain near the wides of the sell-off. Ted spread is the difference between LIBOR and government yields and measures the stress in bank funding markets. 

Risk measures like high-yield credit spreads, VIX and Ted spread remain elevated
Risk indicators such as high yield spread, VIX and Ted spread are still elevated
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On a sector level, the areas that sold off the most had the biggest bounce. Energy (XLE) rallied 44% as renewed OPEC discussions about a production cut helped to stabilize oil prices. Real Estate (XLRE) was the biggest gainer with a 40% rally. The sector had been previously in free fall due to funding concerns and revenue exposure to closed retail stores. Tech (XLK) and Communications (XLC) rallied less than the market because both sectors had previously outperformed during the market decline and didn’t benefit as much from the reduced risk premium. 

Sector performance since SPX bottom on March 23
Normalized sector performance
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Stocks with a steady dividend yield outperformed the market on an absolute and beta-adjusted basis. Utilities sector (XLU) has outperformed since the March 23 bottom, up 35%. REITs that focus on cell-phone towers and data centers are trading near highs (AMT, EQIX, CCI, DLR, SBAC, COR). 

For the overall stock market, dividends are at risk of being cut because of declining cash flows and uncertainty about a rebound. Currently, 389 stocks in the S&P 500 have a dividend yield more than the 10-year Treasury rate of 0.7%. Stocks that can weather the current turmoil without a dividend cut represent an attractive investment in a yield-starved world and candidates for further inflows. 

S&P 500 dividend yield exceeds 10Y Treasury yield by a wide margin
S&P 500 SPX dividend yield is higher than 10-year treasury yield
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239 stocks in the S&P 500 have a dividend yield above the 10-year Treasury yield
239 stocks in the S&P 500 have a dividend yield higher than the 10-year treasury yield
Made with Market Scatter function on Koyfin

The unprecedented government stimulus is bullish for precious metals

The impact of the recent Fed action on the real economy is yet to be determined. If the economy doesn’t improve, it’s almost certain that the government will continue to increase stimulus through current programs or new ones. US officials have suggested that more stimulus is likely through an expansion of the current programs and new infrastructure spending. 

In the US, the Fed balance sheet has already increased by 50% from $4 trillion in February to $6 trillion. The ECB has also increased its balance sheet to 5 trillion Euros, though at a slower pace than the Fed. The fact that yields on government debt remain low will provide cover for policymakers to continue and potentially expand quantitative easing (QE) policies. 

FED and ECB balance sheets have expanded rapidly as QE programs were restarted
Fed Balance Sheet and ECB Balance Sheet size are growing due to QE
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The most direct beneficiaries of the QE theme are precious metals and miners. In a world with prolonged QE, the uptrend in precious metals like gold and silver will likely continue. Investors can play this theme through ETFs of precious metals like Gold (GLD) or Silver (SLV). Alternatively, the Gold Miners (GDX) or Silver Miners (SIL) ETFs provide further operating leverage to an increase in precious metals prices.

Precious metals and miners ETFs
Gold, Gold Miners, Silver, Silver Miners, GLD, GDX, SLV, SIL
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The outlook for equities has improved since March 23, though significant uncertainty remains. Investors need to be mindful of the outstanding risks but also consider that equities usually bottom well before a recession ends. 

The analysis in this blog post was done using Koyfin which offers financial data and analytics to research stocks and understand market trends. Create a free account on our website.