Third Quarter Market Update
Remember February 19th, 2020? That was when the S&P 500 hit its all-time high and was up 5.12% for the year. Then came the storm which was COVID-19. After dropping at a velocity not seen before in the history of the stock market, the S&P has rallied over 51% since those March 23rd lows. The second quarter of 2020 was the mother of all economic contractions. Real GDP shrank at a 31.7% annual rate, the largest drop for any quarter since the Great Depression. However, based on the economic reports we have seen thus far, it looks like the third quarter will be the mother of all economic rebounds. What is important to recognize is that even if Real GDP equals or exceeds the percentage drop in the second quarter, the economy is still in a very big hole. Take for an example a company that makes blankets. Say this company makes 100 blankets and production drops 20%, this means that now they only have made 80 blankets. If production then goes up 20%, that growth rate is lower than the base, so a 20% increase only gets you back to 96 blankets. The bottom line is that a full recovery is probably still years away. This surge in the third quarter is largely related to many companies going from a total lockdown to the new COVID normal.
This suggests that although growth should continue into the 4th quarter, it cannot nearly be as fast. You can only re-open your business once. This sharp recovery we have seen has been largely influenced by monetary and fiscal policy. Economic activity has largely improved from very low levels, but the pace at which this can continue depends largely in part on the trajectory of COVID and on continued policy support. As we have talked about in earlier market reviews, it is largely the consumer that drives economic activity here in the US. As the economy started to re-open, consumer sentiment improved significantly and does continue to trudge along upward. The election though has begun to have an impact on expectations about future economic impacts. The same can be said about the market. Remember, the stock market loves certainty and with presidential elections, comes uncertainty. Even with all this uncertainty, if Joe Biden does win the election and the Democrats do take the Senate, it will likely be by a very narrow majority. In that instance, we would imagine that some democrats would balk at immediately imposing tax hikes. Remember, when President Obama took office in 2009, the Democrats had 59 seats in the Senate, and taxes did not go up until 2013. This was because Democrats were hesitant to hike taxes when unemployment was high, and the economy was slowly recovering from the Financial Crisis of 2008-2009. Sound familiar?
Within our portfolios here at Sgroi, the biggest thing that we try and do is to eliminate unsystematic risk. There are two different risks associated with the market, one being systematic risk, which is related with the entire market and cannot be eliminated. The other is unsystematic risk, which is risk that only affects a particular company, country, or sector and its securities. This risk is not correlated with stock market returns. Because we do foresee some choppy markets conditions moving forward, especially with how big of a run the market has had these past months, it is important to remember why diversification is an important tool in constructing a portfolio. Each asset class responds differently to different types of risk, therefore, diversifying among asset classes is a proven way to reduce overall risk, dampen volatility, and improve the performance of a portfolio. With that being said, we have added in gold and have an overweight to those core bonds, which have shown to be non-correlated to equity returns. Because we do have these “hedges” in our portfolios, we can continue to play some offense on the equity side, as we can ride any momentum the stock market may have left for these last months of the year. We do not have any significant bets on the table, as question marks remain about the pace of the recovery and what will happen with the presidential election.
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