Stone's Weekly Market Guide - Week of July 20, 2020
Chart of the Week: Though small-capitalization stocks outperformed last week, they have underperformed year-to-date (YTD) and on the surface valuations look challenging. The methodology regarding small-cap index construction does lead to some interesting divergences currently. Generally, the Russell 2000 is simply the smallest 2000 companies within the Russell 3000 index. The S&P 600 is a smallest capitalization subset of the S&P 1500 with the constituents at the discretion of their Index Committee. Among the S&P’s eligibility requirements are that the company should be profitable over the past year and most recent quarter. More details about their respective index methodologies are here and here. With about 42% of the Russell 2000 constituents currently unprofitable according to Strategas Research Partners, this leads to a large difference in valuations with the Russell 2000 and S&P 600 trading at approximately 29- and 20-times next year’s estimated earnings respectively. Small-cap companies have more leverage than large-caps with the Russell 2000’s estimated net debt relative to earnings (Net Debt/EBITDA) for next year more than 3-times the level of the S&P 500. Small-caps are typically less exposed internationally with the Russell 2000 getting about 22% of sales overseas versus 40% for the S&P 500 according to FactSet. Conclusions: When using the S&P 600 to remove the distortion from the non-earners, small-cap stocks do not look expensive relative to large-caps so a continued allocation to small-cap stocks is likely warranted despite the added leverage risk. The Russell 2000 has significantly outperformed the S&P 600 both YTD and since the March bottom in stocks driven primarily by the outperformance of the money-losing companies. With its focus on profitability, the S&P 600 has significantly outperformed the Russell 2000 over the long-term. Switching from the Russell 2000 to S&P 600 could be an interesting opportunity to improve future performance and reduce risk. It is even more interesting if the investor is taxable and can realize a loss in their Russell 2000 holding. While the Russell 2000 and the non-earners could certainly continue to outperform perhaps due to fiscal stimulus and central bank support, a shift to S&P 600 exposure looks prudent.
Week in Preview
· Geopolitical: With lockdown measures being re-introduced in parts of the U.S. and globe to combat a resurgence in COVID-19 infections, the impact on economic activity will be closely monitored. So far, the uptick in infections has slowed the momentum of the economic recovery on the margin but has yet to reverse the positive direction.
· U.S.: Attention will be on negotiations over the next fiscal stimulus package. With the additional $600 per week unemployment benefit from the CARES Act expiring at the end of July, the extension of some amount of additional benefit to support spending will be watched closely. The package is also expected to include state and local aid which will be important for the municipal bond market. June housing data should continue to point to a robust recovery in residential construction. The July Markit PMI reports will provide another look at the current state of the recovery and should reflect continued improvement. Initial jobless claims were higher than expected last week and will again be watched to judge the impact of rising COVID-19 cases on employment. Readings for our U.S. Reopening Monitor improved last week with initial readings on new COVID-19 cases and deaths in the U.S. falling on a week-over-week (W/W) basis. The negative impacts of rising infections are continuing to show up in the underlying high frequency economic data for restaurant dining, airplane travel and public transit usage. Please see our weekly U.S. Reopening Monitor and our Guide to the U.S. Reopening Monitor for more details.
· S&P 500 2Q Earnings Season: 2Q earnings season has a wider range of sectors and 92 S&P 500 companies reporting. According to FactSet, 73% and 79% have beaten consensus earnings and revenue estimates respectively with 9% of companies reporting. The 2Q blended (actual and estimates) earnings decline improved to -44.0% year-over-year (Y/Y) from -44.6% primarily due to positive surprises from the healthcare sector. The banking sector reported quite a few earnings beats, primarily driven by strength in the capital markets business, but those positive surprises were mostly offset by earnings misses from Wells Fargo and PNC. As noted last week, 2Q actual earnings seem likely to beat estimates with the bar so low and some companies could reinstate guidance which would be a positive in removing some unknowns. 2020 earnings estimates were little changed last week at -21.1% Y/Y and 2021 estimates at +29.5% Y/Y.
· Europe: Negotiations are ongoing but European Union (E.U.) leaders have reportedly reached a compromise on the proposed EUR 750 million recovery fund. The Eurozone and U.K. should see improvement in their July PMI data.
· Asia: China has an empty calendar. Japan reported June trade data with exports and imports improving to -26.2% and -14.1% Y/Y from -28.3% and -26.2%. July PMI readings from Japan should improve from very depressed levels for June.
Central Banks: The central banks of Kazakhstan, Nigeria, Hungary, Ukraine, Turkey, South Africa, Russia and Angola are scheduled to meet with Hungary, Ukraine, South Africa and Russia expected to lower their policy rates.
Week in Review
· Stocks rose by 1.3% for the S&P 500 with eight out of eleven sectors higher for the week. U.S. economic data was constructive with the better than expected June retail sales. A high rate of coronavirus infections continued, but positive vaccine news helped offset those worries. Industrials (5.8%), materials (5.4%) and healthcare (5.1%) outperformed the S&P 500, while consumer discretionary (-1.6%), technology (-1.2%) and communication services (-0.9%) were the biggest laggards. WTI (+0.1%) and Brent (-0.2%) oil were little changed with MLPs (2.4%) and the energy sector (2.9%) outperforming. Small cap stocks outperformed the S&P 500 with the Russell 2000 higher by 3.6% with small cap value stocks helping the index by gaining 4.3%. The 10-year and 30-year U.S. Treasury yield were lower at 0.63% and 1.33% respectively.
· High yield credit spreads slightly narrowed reflecting increased risk appetite. AAA municipal bond yields as a percentage of Treasuries decreased, causing municipal bonds to outperform. The negative revenue impacts of the economic lockdown on local governments and talk of state bankruptcy have driven municipal bond valuations to low levels relative to Treasuries. Allowing states to declare bankruptcy should remain an unlikely outcome with the heart of the issue really about the size and distribution of Federal government aid. Additional support for the states is likely to come in the next stimulus bill.
· The U.S. dollar was weaker against developed market currencies but slightly stronger versus emerging market currencies. Developed international stocks as measured by MSCI EAFE outperformed the S&P 500 returns in U.S. dollar terms (2.2%) and on a hedged-currency basis (2.0%). Emerging market stocks underperformed the S&P 500 with the non-hedged return of -1.3% for MSCI EM.
· The 10-2 yield curve narrowed slightly to +48 basis points. Another curve measure of three-month yield six quarters forward minus the current three-month yield rose to +5 basis points. The yield curve has historically provided an accurate forecast of future recessions when the difference in these measures turns negative, also known as inversion. Yield curves are one of the major indicators that we monitor to judge recession risk, but these inversions typically happen more than a year in advance of an economic recession but external shocks like the current coronavirus-induced recession might not be accompanied by one. Stocks have historically had significant advances post-inversion.
The PDF version of Stone's Weekly Market Guide is linked here.
The Guide to the U.S. Reopening Monitor is linked here.
The weekly update to the U.S. Reopening Monitor is linked here.