June 15, 2020
By Matt Kelley
Portfolio Strategy Manager, ESL Federal Credit Union
May was the second positive month in a row for the S&P 500, up 4.7% in May as of writing. This follows the best monthly return for the S&P 500 since 1987, finishing +12.7% for April. Year to date, the S&P 500 is down ~5%. A natural question would be, “with the economy facing arguably the worst economic crisis since the Great Depression, with unemployment still incredibly high at 13.3% for May, how can the market be down only 6%?“
One answer could be the unprecedented monetary and fiscal stimulus the government has provided, between the $2 trillion CARES act as well as numerous Federal Reserve facilities intended to provide liquidity and funding, including the purchases of corporate bonds discussed last week. The stock market is also a forward-looking animal, not reacting to current data, but anticipating future data. The S&P 500 could be pricing in a faster return to normalcy than people expect.
Some Positives in Recent Unemployment Numbers
In the last week of May, the unemployment report confirmed another 2 million initial claims, however, continuing claims for the week ending May 16 dropped to 21 million, down from 25 million the week prior. This is the first drop in continuing claims since the start of the crisis. This drop could signal workers returning to the workplace because of some areas reopening or the restart of paychecks for temporarily unemployed workers from the Paycheck Protection Program (PPP). In either case, the unemployment figures should to be taken with a grain of salt; it does not include workers filing for unemployment or other federal programs such as Pandemic Unemployment Assistance, which is reported with an additional week lag. As of May 9, there were almost 31 million people claiming unemployment benefits in all state and federal programs. We will know more from the May jobs report.
An Explainer on Divergent Markets
The bond market is another potential driver of the divergence between the stock market and the economy. With cash and Treasury bond rates at zero, or close to it, investors are faced with the choice of market volatility, or locking in next to zero returns in the cash and bond market. It is very possible that investors are viewing the stock market as being one of the few areas offering positive future returns.
One possible cause for the discrepancy between the stock market and the economy might be the composition of the benchmark we are looking at, in this case the S&P 500. The S&P 500 is a market cap weighted index, meaning that the largest companies hold the largest allocations. Currently, the top five names in the S&P 500 (Microsoft Corp., Apple Inc., Amazon.com Inc., Alphabet Inc., and Facebook Inc.), make up more than 20% of the index. As of writing through May 2020, all five companies have positive performance for the year, ranging from up 6% (Google) to up more than 30% (Amazon)! With 20% of the index up 14% on average through the year, the remaining 80% must be performing worse on average, for the overall index to be down 6% year to date. The S&P 500 equal weight index, which removes the mega cap bias by equal weighting the positions, is down 12% year to date. The largest companies in the S&P 500 index are delivering substantial outperformance, relative to the median company. This becomes clearer when looking at the smallest public companies, referenced by the Russell 2000 index, down more than 16% year to date.
Sector composition and performance provides another layer of information. There is a wide dispersion across S&P 500 sector performance. The four largest sectors in the S&P 500 index are Technology (26% of the index), Healthcare (15%), Communication Services (11%), and Consumer Discretionary (10.5%). These are also the four best performing sectors year to date, with Technology leading the way at +7.4% as of writing. Energy and Financials, the worst performing sectors, are down 34% and 23% respectively. These sectors are still market cap weighted, and similar to above, could be seeing a benefit from their largest constituents. When diving deeper, we see that all of the best performing sectors, with the exception of healthcare, have performed better than their equal weighted counterparts. Microsoft and Apple comprise more than 40% of the Technology sector, Amazon makes up 23% of Consumer Discretionary, and Facebook and Google are more than 44% of the Communications Sector. This signals that it is still the largest names that are pulling up market performance.
Stock Market ≠ Economy
Another issue? The stock market is not the economy. A 2018 report by the US Small Business Administration showed that Small Businesses (in this case defined as less than 500 employees) employed 47.5% of all US Employees. Many of these businesses are not public, and none of them is in the S&P 500 index. Small businesses have shouldered much of the pain during this crisis. A recent study by the NBER showed that 43% of small businesses surveyed had temporarily closed. Furthermore, small businesses had reduced employee counts by 40%, on average, and the median company has less than one month of cash on hand. The pain of small business is not directly reflected in the stock market.
Recent performance of the S&P 500 could be signaling a light at the end of the tunnel. There is also much uncertainty ahead surrounding reopening the economy, a second surge of coronavirus cases, a return to normal consumer spending, and more. It is possible that the S&P 500 is pricing in a best-case scenario, with any bump in the road spelling more volatility for investors. Regardless, while the stock market can be a leading indicator, it is not a direct reflection of the broad US economy.
Matt Kelley is a Portfolio Strategy Manager with ESL Federal Credit Union. In his role, Matt oversees the portfolio strategy team at ESL and is responsible for the investment philosophy, approach, and overall performance of internal and external investment portfolios for ESL.
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