Market Insights: Third Quarter Wrap-up

Market Update

It has now been more than six months since the World Health Organization declared the global COVID-19 pandemic, upending our home and working lives. As the initial wave of infections subsided and the spread of the virus stabilized through the summer months in most parts of Canada, we adapted to the “new normal.” Heading into the fall, infection rates in some provinces are rising again, raising the possibility of further restrictions to limit the spread of the virus. Amidst the ongoing uncertainty, we first and foremost hope that you and your family are keeping well.

Recovering from the pandemic-related downdraft of the first quarter, financial markets enjoyed a period of relative calm and optimism through the summer of 2020. Equity prices in many markets continued to improve, with some sectors (especially large cap technology) moving sharply higher as lockdown restrictions eased and economic activity gradually resumed. Toward the end of the third quarter, however, investor concerns resurfaced. In September, markets were rattled by growth in the numbers of COVID-19 infections, uncertainty related to the upcoming U.S. presidential election and the expected economic stress of reductions in government supports for businesses and individuals.

Most global equity markets started the quarter positively, led largely by investor optimism for sectors expected to benefit from current conditions, such as technology and health care. The S&P 500 Index, a broad representation of the U.S. equity market, reached an all-time high in early September before volatility resurfaced as the quarter ended. The U.S. index finished the three-month period up 8.9% for the quarter and now up 5.6% year-to-date (YTD) on a total return basis including dividends.

However, it is critical to point out that this is mostly driven by a handful of mega-cap technology names. This is evident when you look at the S&P 500 Equal Weight Index, widely viewed as the better indicator of the overall large cap U.S. equity space. It was still down 5.2% YTD at the end of September. This is a 10.6% gap from the market-weight and equal-weight index which is about as extended as it gets. An even broader measure of the U.S. market is the NYSE Composite Total Return Index, down 6.9% YTD.

In Canada, the S&P/TSX Composite Index also trended higher through much of the summer, buoyed by sectors such as materials (precious metals), industrials (transportation companies) and consumer staples. Despite continued weakness in the energy sector and broader market volatility later in the quarter, the Canadian benchmark finished the three-month period with a gain of 4.7% but remained down 3.1% YTD on a total return basis.

Central banks around the world continued to gauge the ongoing economic impact of the pandemic in setting monetary policy. The U.S. Federal Reserve, for example, noted that the U.S. economy had picked up considerably, but much depends on the confidence of consumers to spend. The central bank indicated that it would allow inflation to exceed 2% as the economy recovers and that its target interest rate would be left unchanged at 0-0.25% for “an extended period.” The Bank of Canada also kept its benchmark interest rate steady during the third quarter at 0.25% and said it would continue its large-scale government bond purchase program designed to promote liquidity in the financial system.

The decline in interest rates has supported bond prices over the past several quarters, particularly longer dated government bonds, resulting in the FTSE Canada Universe Bond Index, a broad measure of Canadian government and corporate bonds, to return 0.4% for the quarter and 8% YTD. It remains our view that there is a great deal of interest rate risk in holding fixed income exposure with similar traits to this bond index, not to mention a yield-to-maturity of just ~1%/year for the next decade, before inflation, taxes and fees. Our fixed income exposure remains tilted towards corporate credit and below average maturities.

Milestone strategy and outlook

So far, 2020 has reminded us of several important lessons, one of which is that timing the market is nearly impossible. Many people would have sold their investments shortly after the U.S. market declined nearly 34% in March, believing that a recovery would be a long way off. And that is the case as evidenced by the massive amount of equity mutual fund outflow in March. But from its lowest point on March 23, the S&P 500 took just 140 days to recover – the fastest rebound on record. Those who stayed invested would likely have been rewarded for their patience, while those who sold would have locked in losses.

Looking ahead, the COVID-19 pandemic is still likely far from over and will have an impact on investment markets for months to come. However, governments and central banks continue to provide historic support for the economy through accommodative fiscal and monetary policies. This low interest rate environment and backstopping of credit globally is key to allowing the markets time to recover, and recover they will. Although the economic outlook remains unclear, particularly if further restrictions to limit the spread of the virus become necessary, we remain steadfast in our belief that the worst is behind us and that the secular bull market that began is 2009 remains intact. For this reason, keeping a long-term view will be especially important.

After getting over the first big speed bump in September, there has been no measured progress in the next U.S. stimulus package, an increased likelihood of a democratic sweep in the November elections, and a spike in COVID-19 spread. Despite these seemingly negative issues, the market is moving higher once again in early October. This time, we are seeing the rally broaden as we will show in the following charts.

For the last six months, we have been sending weekly email updates on the economy and markets as well as our strategic views and outlook as we navigate through these unprecedented times. We hope you will continue to find value in this. In some of our latest updates, we showed that the underlying metrics for the market have been positive, capping off this past week with new highs in an important breadth indicator called the Cumulative Advance-Decline (A/D) Line. Our update discussed the large cap S&P 500 index, but now we are seeing a broadening scope of this strength. Here is a chart of the A/D line for the NYSE Composite, the broadest measure for the U.S.

Source: Canaccord Genuity Corp.

In the past several years, the cumulative advance-decline (A/D) line has consistently led price to new highs coming out of market pullbacks. This indicator is giving an early signal that the probability of a new all-time high for the index in the short-term (weeks) has risen dramatically. This could also extend to Canadian equity markets. A new all-time high in the A/D line does not guarantee a new all-time high in the index, but it certainly serves as confirmation of the positive trend we have seen of late. What is interesting is that the NYSE Composite is still 7% below its all-time high from January, indicating there is plenty of upside opportunity.

In addition, we have discussed at length the strength of the market-weighted S&P 500 Index led by U.S. mega-cap technology, however, we are finally now starting to see some strength from small-cap companies which is viewed more as a value than growth index. As of this writing, the Russell 2000 Small Cap Index has been up more than 10% in the last 10 trading days. According to Sundial Capital, via the chart below, this has occurred 20 times in the past 40 years. When this has occurred, we have seen very positive forward-looking results, with a median gain of 5.9% over the next 3 months with a 100% probability of a positive return, and median gains of 16.6% over the next year with a 89% positive return probability. As always, past performance is not indicative of future results. However, we view this as positive traction heading into the last quarter of the year and our portfolios would greatly benefit from a broader rally as opposed to one more centered in large-cap technology and healthcare.

Source: Sundial Capital

Here is our Milestone Market Report on capital markets, commodities, and currencies through September 30th and economic data through October 2nd, 2020: (click image for PDF version)

 

Sources: Globe & Mail, CBC, CNBC, CI Investments, Trading Economics, Canaccord Genuity, TD Wealth, Bloomberg, Thomson Reuters, Sundial Capital, Bespoke Investment Group.