8/26/20: The S&P 500 has continued its surge after closing on August 18 at a record high, erasing the losses sustained from the coronavirus-induced selloff last March and returning to pre-pandemic levels. The snapback has been astounding, as if the pandemic had never happened. It took only 126 trading days for the S&P 500 to reclaim its February peak – 10 times faster than the index’s average historical rebound period of 1,542 trading days, according to Barron’s. This remarkable performance has prompted our clients to ask us why the market has done so well while the economy continues to suffer. A cartoon in this week’s Economist captures the sentiment.
The COVID-19 economy has been predicted and depicted as a “V”, a “W”, a “U” or, as Cresset described, a square root sign. However, we think it’s now looking more like a “K” underneath the surface, with the ability to work remotely being the difference between swimming in this economy, or sinking. The technology wedge has created two Americas: a prosperous one comprising professionals who are largely “back to work” and a failing one comprising out-of-work service employees who can’t work from home. The automation chasm traces back centuries, but COVID-19 accelerated the split between skilled and unskilled workers. Twenty years ago, the number of jobs requiring a high school diploma was the same as the number of jobs requiring a college degree. Today, there are 57 million more American jobs requiring higher education and 6 million fewer positions for high school graduates, many of which were eliminated by technology. Since the pandemic, job losses among less-educated workers outpaced skilled job losses by a factor of more than four to one.
The stock market, for all its top-line success, is also experiencing a “K-shaped” divergence underneath the surface. Most stocks have not hit their pre-pandemic levels. According to CNBC, 38 per cent of stocks in the S&P 500 Index have gained ground since the previous high on February 19, while 62 per cent have posted losses. One-quarter of the S&P 500, a total of 126 stocks, have suffered declines in excess of 25 per cent from the pre-pandemic peak. In fact, one-fifth of S&P 500 companies are wallowing more than 50 per cent below their all-time highs, while the equal-weighted S&P 500 remains more than 6 per cent below its February 19 peak.
This underscores a simple fact: Wall Street is not Main Street. The S&P 500 represents the 500 largest publicly traded companies in the country. The smallest S&P 500 constituent, Coty, a manufacturer and distributor of beauty products and luxury goods (think Tiffany), has a market capitalization of $2.9 billion; the company employs 19,000 people. Main Street, by comparison, is comprised of small businesses. Half of America’s workforce is employed by companies of 500 employees or fewer, according to payroll processor ADP. One-quarter of workers are employed by companies of 50 employees or fewer.
Wall Street is dominated by corporate behemoths. The top five companies of the S&P 500 – Facebook, Amazon, Apple, Microsoft and Google (FAAMG) – account for more than one-quarter of the rally since March, and each have reached new highs this month. The combined FAAMG market cap of $7.3 trillion represents 38 per cent of US economy, yet collectively these companies employ less than 1 per cent of the US workforce. S&P Information Technology, one of the most insulated sectors in the pandemic, represents 27 per cent of the market yet only 1.8 per cent of America’s workforce. At the same time, the leisure and hospitality industries, among the hardest hit in today’s pandemic, employ more than 10 per cent of America’s workforce yet only account for less than 3 per cent of the S&P 500.
Despite the near-term challenges, we at Cresset still like equity investing. That’s because equity investing is a long-term endeavor. Current stock prices represent the present value of all future earnings and dividend streams; only a small fraction of today’s stock prices comprise this year’s and next year’s earnings and dividends. Most of the market’s value is derived from cash flows that span more than a decade. Goals-based investing is all about matching investments and cash flow needs, with short-dated assets, like bonds, delivering near-term cash needs and longer-dated investments, like equities, driving longer-term cash flows. Pandemic or not, history shows that equity investing requires a minimum 7-year time horizon to improve one’s odds of success.
Two issues could alter our bullish outlook, however. One is inflation. While we don’t see an inflation threat on the horizon, persistent pricing pressure that could reverse the favorable interest rate trend would prompt us to reduce our equity exposure. The second issue is valuation. Cresset’s growth strategy is predicated on a 90 per cent success rate in achieving a positive return over a 7-year holding period, and valuation is the most important determinant of that success rate. A valuation metric that causes our forecast success rate to drop below 90 per cent would prompt us to reduce our equity exposure, as we did in late 2019. The COVID-19 pandemic is causing disheartening dislocation and hardship. The discipline of maintaining a longer-term time horizon bolsters our confidence that the world will eventually move beyond the pandemic, a more normal life will resume and new opportunities on Wall Street and Main Street will drive future prosperity.