2020 Third Quarter Review and Outlook

The third quarter was another strong quarter for the stock market. The S&P 500 Index returned 8.93% for the third quarter, although it ended the quarter on a sour note. The index was down in September, the first down month since March. In the fourth quarter, we expect increased volatility in the markets driven by uncertainty of a coronavirus vaccine and the upcoming U.S. election. We recommend that clients maintain a neutral asset allocation and be prepared to add to equities if we see a significant pullback. 

The stock market is forward looking but it hates uncertainty. Part of the market’s pullback in September was due to the upcoming election. Most polls favor Joe Biden over President Trump. These same polls also favored Hillary Clinton in the last election and have created some doubt to the validity of the polls.  There will be a significant increase in voting by mail. With an extended deadline to count the votes it could take weeks or even longer to declare a winner. In the 2000 election of Bush versus Gore, the Supreme Court settled the Florida recount on December 12th – more than a month after the election. Between the election and the Supreme Court decision the S&P 500 Index dropped 7%. We view a pullback because of delayed election results as a possible opportunity to add to equities. 

The Senate races are as important as the presidential election. Most polls show the Democrats winning a one or two seat advantage in the Senate. However, Senate polls have been less reliable in the past and several races are within the margin of error. If the Democrats win the Presidency and the Senate, it increases the likelihood of higher corporate taxes which means lower earnings per share for the S&P 500 Index. A large stimulus bill could help offset the negativity of the corporate tax increases.

A frequent question over the last six months is how the market can be up so much with the obvious economic struggles. The stock market is forward looking and expecting most businesses to rebound in 2021. There are also some structural long-term trends in favor of investing in the stock market. U.S. stocks have seen a decrease in the supply of stocks available for investors. The Wilshire 5000 Index is a market capitalization index composed of companies that are headquartered in the U.S. and listed and actively traded on U.S. stock exchanges. On July 31st, 1998, the index had 7,562 companies. Currently, the index only has 3,451 companies. This significant decrease of publicly traded companies over the last 20 years means that investors now have a lower supply of available stocks to invest in. 

Change in Outstanding Shares (in millions) for Select Companies in S&P 500 

Another long-term trend contributing to the stock markets rise is the decrease in shares available for purchase. In 2009, Apple had over 25 billion shares available. Thanks to share buybacks, Apple now has approximately 18 billion shares available (a decrease of nearly 30%). Most large cap companies have followed the Apple model of issuing debt to fund stock buybacks. Apple had no long-term debt in 2009 and now has over $94 billion in debt. Fortunately, Apple still has close to $100 billion in cash. Economics teaches us that if you leave demand equal but decrease supply you will see prices rise. The trend since 2009 has been fewer companies with less shares available for investors to purchase.

These long-term trends help explain part of the stock markets rise since 2009. However, these trends are not the reason for the stock markets strong performance since March. The Federal Reserve is the major reason for the strong stock market return since March. At the start of 2020, the Federal Reserve had a balance sheet of just over $4 trillion dollars. The Federal Reserve currently has a balance sheet just over $7 trillion – an increase of $3 trillion dollars. The Federal Reserve increased the balance sheet by purchasing U.S. Treasury securities, agency mortgage-backed securities and corporate bonds. The Federal Reserve has committed to keep interest rates low for the foreseeable future and even let inflation increase over their 2% target to support the economy. Currently, the 5-year U.S. Treasury is yielding .28%. This compares to the S&P 500 Index which yields 1.69%.

Low interest rates help the economy by providing cheaper loans and mortgages. However, low interest rates also encourage speculation. This can be seen in the creation of special purpose acquisition companies (SPACs). SPACs are entities that have no operations of their own. Sometimes referred to blank check companies, they are used by managers to acquire a business looking to go public. The money is raised before a company is purchased. Therefore, investors must have faith that the manager is going to use the proceeds in a prudent manner. More than $45 billion has been raised across 120 offerings in 2020. This compares to 59 deals and $13.6 billion in 2019. We think his is a sign of the markets speculative fever searching for the next great growth stock.

The S&P 500 Index returned 8.93% for the third quarter and for the year has returned 5.57%. Large Cap stocks continued to outperform other asset classes. The S&P Mid-Cap Index returned 4.77% for the third quarter and has returned -8.62% for the year. The S&P Small Cap Index returned 3.17% for the third quarter and has returned -15.25% for the year. Large cap stocks tend to outperform during economic downturns. Large companies tend to have stronger balance sheets and easier access to capital compared to smaller companies. We continue to recommend overweighting large cap stocks compared to mid and small cap stocks.

U.S. Large Cap stocks continue to outperform the rest of the world. International equities, as measured by the MSCI EAFE Index returned 4.72% for the third quarter and returned -7.18% for the year. Emerging markets, as measured by the MSCI Emerging Markets Index returned 9.38% for the third quarter and returned -1.56% for the year. We continue to recommend overweighting U.S. stocks compared to international stocks. Fixed income, as measured by the Barclays U.S. Aggregate Bond Index returned .62% for the second quarter and returned 6.79% for the year.  

As we discussed at the end of the first quarter, there was a large range of earnings estimates for the S&P 500 for 2020 and 2021 due to the coronavirus shutdowns. Investors have focused on 2021 earnings with the expectation that most of the economy will be fully operational. Most analysts have an earnings range between $160 and $170 for 2021. The S&P 500 has a ten-year average price to earnings ratio (P/E) of 19.87 and a five-year average of 22.71. Multiplying the lower end of earnings expectations ($160) by the ten-year average P/E (19.87) would produce a target of 3180. Multiplying the higher end of earnings expectations ($170) by the five-year average P/E (22.71) would produce a target of 3860. If the S&P 500 reached that target next year, it would provide a 15% return from the current level. Given the uncertainty of the election and a coronavirus vaccine we recommend that clients maintain their neutral allocation and be prepared to add to equities if we see a significant pullback. 

Investing involves risk, including the possible loss of principal and fluctuation of value.  Past performance is no guarantee of future results.

This letter is not intended to be relied upon as forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.  The opinions expressed are as of the date noted and may change as subsequent conditions vary.  The information and opinions contained in this letter are derived from proprietary and nonproprietary sources deemed by Virtue Asset Management to be reliable.  The letter may contain “forward-looking” information that is not purely historical in nature.  Such information may include, among other things, projection and forecasts.  There is no guarantee that any forecast made will materialize.  All information is illustrated gross of investment advisory fees. Reliance upon information in this letter is at the sole discretion of the reader.  

Please consult with a Virtue Asset Management financial advisor to ensure that any contemplated transaction in any securities or investment strategy mentioned in this letter align with your overall investment goals, objectives and tolerance for risk.

 Additional information about Virtue Asset Management is available in its current disclosure documents, Form ADV and Form ADV Part 2A Brochure, which are accessible online  via the SEC’s investment Adviser Public Disclosure (IAPD) database at www.adviserinfo.sec.gov, using CRD#283438. 

Virtue Asset Management is neither an attorney nor an accountant, and no portion of this content should be interpreted as legal, accounting or tax advice.

Investing involves risk, including the possible loss of principal and fluctuation of value.  Past performance is no guarantee of future results.

This letter is not intended to be relied upon as forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.  The opinions expressed are as of the date noted and may change as subsequent conditions vary.  The information and opinions contained in this letter are derived from proprietary and nonproprietary sources deemed by Virtue Asset Management to be reliable.  The letter may contain “forward-looking” information that is not purely historical in nature.  Such information may include, among other things, projection and forecasts.  There is no guarantee that any forecast made will materialize.  All information is illustrated gross of investment advisory fees. Reliance upon the information in this letter is at the sole discretion of the reader.  Please consult with a Virtue Asset Management financial advisor to ensure that any contemplated transaction in any securities or investment strategy mentioned in this letter align with your overall investment goals, objectives and tolerance for risk.  Additional information about Virtue Asset Management is available in its current disclosure documents, Form ADV and Form ADV Part 2A Brochure, which are accessible online via the SEC’s investment Adviser Public Disclosure (IAPD) database at www.adviserinfo.sec.gov, using CRD#283438.

Virtue Asset Management is neither an attorney nor an accountant, and no portion of this content should be interpreted as legal, accounting or tax advice.