Stocks Fall Again; Odds Heavily Favor a Post-Election Rally
This has been an ugly week for the stock market with the Standard and Poor’s 500 index declining 5.6% and all sectors deeply in the red. And also of note, the VIX spike above 40 for the first time in months this Wednesday. Nevertheless, I think risk/reward remains attractive and the odds heavily favor a post-election rally. More on this below.
On the COVID-19 front, in a nutshell, it is spreading and much worse in Europe but mortality is falling. The skeptics would say mortality is low because the virus is making its way to the vulnerable cohorts (lag). Others would point to the “deadwood” issue and many of the vulnerable have already been killed. Therapeutics are far better. And mitigation is better. But the key issue is avoiding the level of policymaker panic that would lead to broad economic shutdowns.
The takeaway is to that wave 3 is really a wildfire through areas of the US that were largely untouched. In fact, if we look at some of the cities at the heart of Wave 1 and Wave 2, we can see that there is hardly a new wave of cases burning across these cities. Daily cases in Florida have hardly increased from their low and remain way off their peaks. And New York City has barely seen a perceptible rise in cases since October 1. And interestingly, this is very different from Europe’s second wave in which the same cities are seeing a resurgence.
The daily change in cases vs 7D ago in the US which, in our view is the key leading metric, is rising but the rate of increase is been constant and the rise does not seem to be accelerating (becoming exponential), which is key. And while hospitalizations are also up, we can see daily deaths are flat to down while daily cases are soaring. This is a reminder that the future is very uncertain. So, while this is a relatively benign picture now, it could also easily worsen.
This week we identified 6 states (Wisconsin, Illinois, Idaho, North Dakota, South Dakota and Utah or simplified to “WIINSU”) that are out-sized contributors to the 3rd wave of cases in the US. These states have remarkably high case prevalence based on daily cases per 1mm. And within each of these 6 states, our data science team identified the 3 key counties, based upon either case prevalence or case velocity (daily cases per 1mm) which bear watching over the coming weeks as wave 3 unfolds as they could provide insight into when wave 3 should peak. And after all, once policymakers and residents panic, we could start to see a mitigation of case growth rates.
STRATEGY: Market weakness creating a positive risk/reward for stocks
It has been a rough run for “epicenter” stocks for the past few weeks. The surge in COVID-19 cases coupled with the delay in fiscal stimulus has weighed heavily. But I still remain constructive on these stocks, even as the past few weeks have been awful.
Mainly, I see US economic momentum strengthening in 2021, even with COVID-19 still surging in the US (less deadly and lockdowns are not needed here). And I see additional reasons Cyclicals, aka epicenter, could see surprisingly strong EPS in 2021: (i) restricted topline environment forces these companies to slash operating costs ala 2008, (ii) demand recovery from either stimulus or vaccine results in operating leverage, and (iii) Price to Earnings ratios can expand because these companies have proven to be “unkillable” by surviving the biggest contraction in modern history.
Investors are reluctant to add risk because they do not know who will prevail on the Election day. And also, they are concerned about a contested election. Would a contested election change the 2020 economic outlook materially?
There is one scenario. The US economy badly needs action on fiscal stimulus. So, if the contested election raises the risk of delaying a stimulus bill until after the new President is sworn in, we could see a delay in the badly needed “financial bridge.”
But if this happened, we believe the Fed would intervene. In other scenarios, we see fiscal stimulus moving forward with the same Fed backstop. So, the odds heavily favor a rally post-election. In short, while people are sitting on the sidelines into election day, we see a rally taking root thereafter.
Bottom Line: This has been an ugly week with the S&P 500 declining 5.6%. I see this weakness as a positive risk/reward and continue to see opportunity in “epicenter” stocks as economic momentum strengthens.
Figure Comparative matrix of risk/reward drivers in 2020
Per FSInsight
Figure: FSInsight Portfolio Strategy Summary – Relative to S&P 500
** Performance is calculated since strategy introduction, 1/10/2019
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