October is traditionally the most volatile month of the year, and this October was no exception. The S&P retreated over 2.3%, while the bond index saw declines around .5%.
OVERVIEW and TECHNICALS
After a rebound from the September slump that took the S&P up from 3,236 on September 23rd to 3,534 on October 12th, the broad U.S. market retreated for the remainder of the month. This drawdown also took the S&P below its 50-day moving average (MA), but neither below the current cycle lows of September 23rd, nor the 200-day MA, which is often viewed as a longer term trend line. Looking back a little further, the market has been in a trading range between 3,230 and 3,580 since mid-July, effectively making no progress for more than three months. This is not a big surprise, as the S&P had rallied some 50% off of the March lows and may have advanced a little ahead of what the fundamentals support in the global recovery. Several headwinds and concerns are impacting the market.
WHATS DRIVING THE MARKET
First, earnings. The final week of October brought us the busiest week of earnings. Some 30% of the S&P constituents reported. Many of the favorite names in the large cap/tech space beat expectations but cautioned about future earnings growth given the uncertainty surrounding the pandemic. This likely causes market participants to question whether current lofty valuations are justified given the future earnings outlook. If the fundamentals do not support valuations, then the market must discount a slower growing economy, notwithstanding the fact that U.S. GDP printed a 33% increase during the third quarter, after declining 32% in the second quarter. Even with the historical quarterly increase in GDP, economic activity is still a long way from pre-COVID levels, and there is more work to be done to get back to those levels.
Second, Congress failed to reach an agreement to provide much needed fiscal stimulus to working Americans and small business — something that is both necessary to support ongoing consumer spending and to keep the recovery on track. If Americans are having trouble paying their basic household bills, they are not spending on discretionary items. Consumer spending accounts for roughly 70% of economic activity, and millions of Americans who are out of work are not able to spend at the level pre-COVID. This will invariably have a negative impact on GDP, even if only for a brief time. We do anticipate a fiscal package will be approved early in 2021, perhaps even larger than one that could have been approved before the election. Supporting Americans and small business will have a positive impact on economic growth.
Third, the election is creating additional volatility. There is a lot at stake, and if there is not a clear winner on November 3rd it will only serve to maintain heightened fear and volatility.
Finally, it appears that Europe, and to a lesser extent, the U.S. is entering a period where new cases and hospitalizations from COVID-19 are on the rise. Should the rising cases result in another round of business closure and lockdowns, an already fragile economy may take another leg down, possibly entering a double dip recession. We do not believe that the U.S. will enforce another national shut down, as we have a lot more information about the virus, and numerous treatment options that seem to be able to reduce the negative impacts of those infected. Further, with an understanding of the economic damage that results from a national lockdown, we do not see this being a recognized viable option, or even necessary at this juncture. If more people simply recognize that we all need to work together to control the spread, we can continue to learn to adjust our lifestyles and live with the virus without having to shut down wide swaths of non-essential businesses. Remember, with each passing day we are closer yet to discovering a viable vaccine to reduce the spread and symptoms of COVID-19.
PORTFOLIO AJUSTMENTS
After observing outsized selling pressure on those mega cap growth/tech darlings that carried us from the March lows to September, we felt it was time to book some profits and reduce our exposure to the largest stocks in the U.S., widely known by the acronym FANGMAN (Facebook, Apple, Netflix, Google, Microsoft, Amazon and Nvidia). Furthermore, there has recently been increased scrutiny of these conglomerates by Congress, where anti-trust filings may very well cause these names to be less attractive by the investing community as they defend their status to the government and argue they are not stifling competition. Increased regulatory burdens could possibly reduce future profitability of these market leading companies.
In early October, we reduced our core positions in QQQ and XLG, and eliminated an underperforming fund, USMV, and re-positioned those proceeds to two new funds, PDP (Invesco Momentum) and PWB (Invesco dynamic large cap growth). These new funds keep us overweight in growth as well as technology and health care (two leading sectors in 2020) but it reduces our reliance on FANGMAN to do most of the heavy lifting. As the market broadens out, and more companies in the S&P 500 participate in and exhibit positive trending characteristics, we inherently become less reliant on the same five or six names to carry the market. We still have reasonable exposure to these FANGMAN companies but are broadening our reach into other emerging and growing large tech and health care names, as well as some industrial and consumer cyclical stocks.
LOOKING AHEAD
As of this writing, our risk mitigation overlay is still indicating a fully invested portfolio. Should the market continue to deteriorate, we anticipate we may begin to trim some equity positions, to varying degrees to reduce risk in a sustained down trending market. However, the longer term trend is still intact, and we feel that after a full resolution of the presidential election, the market will get back to focusing on fundamentals, and what the next four years may favor or not favor, sector and stock wise. There will also likely be less headline risk post-election, which should help stabilize the market as the market looks towards the new year and investors position accordingly.
In conclusion, we are very aware of the heightened risk in the markets as we head into the final two months of the year. We will remain vigilant in seeking out opportunity and managing risk. Please stay safe, keeping yourselves and your family out of harms way, and most importantly VOTE.
