Unpacking the Wall Street/Main Street Disconnect

October 6, 2020

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Executive summary

  • Market indexes have recovered most of their losses from earlier this year, yet remain far from “normal.”
  • Ongoing abnormal market behavior reflects a reopening economy that is finding it difficult to fully recover without a widely distributed vaccine for COVID-19.
  • A robust pipeline of vaccine candidates provides opportunity to transition to a full recovery, but timing remains uncertain.
  • Attention is now turning to the potentially divergent election outcomes, but markets often exhibit very little political bias longer-term.
  • Investors should maintain a neutral equity and risk allocation relative to established investment plans, while seeking opportunity away from the largest U.S. stocks.

Stocks have recovered... on the surface

The stock market has staged one of the fastest recoveries from a bear market in history. On March 23, the S&P 500 hit its low, more than 34% below its high reached just one month prior, amidst growing fears of a COVID-19 outbreak that was spreading faster than medical experts had predicted and medical facilities in certain regions could logistically handle (Exhibit 1).

Less than five months later, after nationwide stay-at-home orders, and significant injections of monetary and fiscal stimuli, the Index exceeded the previous highs on what appeared on the surface to be optimistic, perhaps even overly optimistic, expectations for reopening and an eventual return to normalcy.  

But how normal has the environment really become? COVID-19 was still spreading, schools were just beginning to “reopen,” if you could call it that, and much of the workforce remained dislocated, furloughed or unemployed. And why does it seem that Wall Street seemed so disconnected from the rest of the world on Main Street?

Below the surface, markets appear far from normal

Peeling back the onion just a little, however, reveals that the market may not be behaving so normally after all. The market seems divided into two cohorts, each providing a very different picture (Exhibit 2). The first cohort includes companies unaffected or even benefitting during this period — technology, communications and healthcare. The second cohort comprises companies at the epicenter of the crisis, such as restaurants, retail services, hotels, airlines and energy. Both cohorts felt the sting of the bear market, albeit in much different proportions; however, those companies more impacted by the economic shutdowns and ongoing social distancing have rebounded more slowly and remain ~20% below their pre-COVID-19 highs.

A reopening, but not yet a full recovery

This market action is more consistent with both the anecdotal observations that the current environment is not yet back to normal as well as the more descriptive economic data.

Glenmede’s Reopening Index (Exhibit 3) shows that over 75% of the economic losses experienced during the shutdown have been regained. Progress was quick in the initial stages but has since slowed materially. Our interpretation of this data is that the easiest gains from the April lows have been recouped, and the remaining improvement, while not impossible, will be more difficult to accomplish without a vaccine. This last mile of the recovery will need to occur in areas more directly impacted by the crisis — restaurants, entertainment, travel and energy. 

A vaccine remains key to a faster return to normal

The economy can continue to grow from this new post-rebound level, and healthcare policy and targeted containment efforts may be able to slow the spread and respond to outbreaks. That being said, it is likely that only widespread immunity can bring about a full recovery from the COVID-19 downturn. With less than 10% of the total population in most developed nations having been infected by the virus, herd immunity likely remains well into the future, leaving a nearer-term solution in the hands of vaccine and medical treatment researchers. Perhaps fortunately, advances in vaccine development have enabled a slew of companies to rapidly develop viable candidates. Further, unlike typical vaccine trials that have to wait months or even years to evaluate efficacy, the current widespread and rapid transmission of the COVID-19 virus provides an abundant supply of participants to test that are exposed and at risk of infection. The result is a robust and rapidly progressing pipeline of hundreds of vaccine candidates, five of which in developed countries have already managed to initiate the large-scale phase III trials required for final approval (Exhibit 4). Of course, this does not guarantee that we will have a vaccine in the near future, but it does increase the chances.  

Market’s attention already turning to the election…

Investor concern for the COVID-19 pandemic has moderated as reopening has occurred, the mortality rate of those infected has declined and the economy, profits and even the employment market have at least a partial recovered. However, their attention is now turning toward an additional concern — the uncertainty surrounding the upcoming elections. In fact, the pricing of options on the Chicago Board of Options Exchange (CBOE) suggest that risk remains elevated for a couple of reasons (Exhibit 5). 

First, the difference in the level of the CBOE’s Volatility Index (VIX) in September compared to its pricing in January (left red bar) likely reflects the increase in risk associated with COVID-19. The second reason for today’s elevated volatility appears to be the election, as implied by the additional rise in the pricing of risk from September to October (right red bar). This additional increase in risk is notable, but still smaller than the risk that seems to be due to COVID-19.

…But long-term market returns do not exhibit clear political bias

Again, on the surface, this pricing of risk by markets appears reasonable near-term, but longer-term-minded investors should not presume that it correctly reflects the risk that their investments will fall short of expectations over a longer period of time beyond current events. COVID-19 remains an ongoing near-term concern, but one with some opportunity for longer-term resolution. Similarly, the elections may seem like a potential significant source of risk with campaign policy platforms diametrically opposed on corporate taxes, capital gains taxes, minimum wage regulations and various industry regulations, to name a few. It is possible that some of these campaign pledges make their way to policy, but an election win is not a guarantee of outcomes. History has shown that our government is more than adept at watering down campaign policy platforms before implementation. This is likely why stock market returns have not historically exhibited a clear political bias, despite the typical disparity in policy intentions (Exhibit 6). 

Perhaps this reflects either an understanding that there is potentially limited ability to pass legislation through Congress and/or the adaptive nature of the American economy. While investors should stay apprised of potential policy changes and impacts, they should remain skeptical of any attempts to extrapolate election outcomes to longer-term market performance.

Maintain neutral equity and risk exposure 

So, what should investors do? Market indices appear to have recovered most of their gains, but beneath the surface still convey a failure to return to normal. Both anecdotal and more precise economic data align with this picture that the economy has yet to fully recover from the pandemic, and logic leads to the realization that ongoing gains will likely be slower until a vaccine becomes widely available. Nevertheless, economies have rebounded and continue to grow along with corporate profits. 

Though equity markets have rebounded, the asset class continues to offer relative value and potentially better prospective returns than safer alternatives such as cash or fixed income (Exhibit 7).

Disparate valuations and expected returns between equity asset classes, however, noticeably remain. For example, U.S. small-cap stocks, and well as international developed and emerging market stocks, appear priced to provide better opportunity for investors than U.S. large-cap stocks. However, the lower expected returns for the broad large-cap stock basket is primarily driven by pronounced valuations of a concentrated contingent comprising more than 25% of the index. Further down the capitalization spectrum, opportunities for better returns are more likely, given more subdued valuations. 

As a result, despite near-term uncertainty over the COVID-19 pandemic and election, it remains important for investors to maintain allocations consistent with their financial goals. 
This means resisting the urge to underweight equities relative to their target allocation while remaining nimble and trimming back to target when provided the opportunity. A properly constructed Goals-Based Wealth and Investment approach accounts for unexpected twists and accommodates near-term volatility with a spending cushion or fixed income reserve. These plans enable investors to confidently ride through market declines and rebounds, staying invested in order to meet their longer-term goals.

This writing is intended to be an unconstrained review of matters of possible interest to Glenmede Trust Company clients and friends and is not intended as personalized investment advice. This document is not intended as a solicitation for the purchase or sale of any product or as an inducement to enter into a relationship with Glenmede. Alternative investments, such as private equity, are only available to investors who meet specific criteria and can bear certain specific risks, including those relating to illiquidity. Advice is provided in light of a client’s applicable circumstances and may differ substantially from this presentation. Glenmede’s affiliate, Glenmede Investment Management LP, may conduct certain research and offer products discussed herein. Opinions or projections herein are based on information available at the time of publication and may change thereafter. Information gathered from other sources is assumed to be reliable, but accuracy is not guaranteed. Outcomes (including performance) may differ materially from expectations herein due to various risks and uncertainties. Any reference to risk management or risk control does not imply that risk can be eliminated. All investments have risk. Clients are encouraged to discuss the applicability of any matter discussed herein with their Glenmede representative. Nothing herein is intended as legal advice or federal tax advice, and any references to taxes which may be contained in this communication are not intended to and cannot be used for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promotion, marketing or recommending to another party any transaction or matter addressed herein. You should consult your attorney regarding legal matters, as the law varies depending on facts and circumstances.