Eye on COVID-19, Trifecta of Positive Catalysts Suggest Rally

Summary

– COVID-19 case trends have appeared to tick up and the 7D delta has been positive for two consecutive days, we will watch very closely for market implications.

– 16 out of 50 states are showing a rise in cases vs. 7D ago. This could be noise or ‘true-up’ caused by delayed reporting but we’ve noticed some correlation to vaccination rates.

– We think several positive factors are aligning for the first time in a while that will make our mid-year S&P 500 target plausible including, a falling VIX, high-yield debt markets, and situation around rates.

– The market’s rally in the wake of a rough week influenced by Quad-Witching and FOMC meeting bodes well and market made two all-time-highs this week.

US daily cases are not really showing much improvement of the past few days when looking at the 7D delta and although the rise is only currently occurring in 16/50 states, we will continue to watch this very closely. This is much less severe than the upturn in cases seen in the UK but the rate of improvement does appear to be slowing.

When looking closer at whether or not the difference could be accounted for by vaccine penetration there appears to be a potentially causal relationship. Tireless Ken put this chart together showing the “delta in cases per 1mm” to normalize for the population.

States with more cases per 1mm residents generally have lower vaccine penetration. Typically, these states have levels of vaccinated residents below the 40% level. Two exceptions to the relationship we’re seeing are Washington and Delaware. Both states have higher than average vaccine penetration.

This is a reminder that variants and mutations are creating risks of greater transmissibility. Fortunately, the mRNA vaccines are shown to be highly effective against variants, so the mutations are not eluding the vaccinations.

However, for the unvaccinated Americans the risk of catching COVID-19 is actually rising even though perception may be the opposite. This is true even though case prevalence is failing. Higher transmissibility means the risk of catching COVID-19 from exposure is higher for those without protection.

There were a total of 806,240 doses administered on Thursday. Over the past 7 days, 809,544 doses were administered per day on average, down 38% from 7D ago. As the chart below shows, the vaccination pace has slowed down significantly over the past few days compared to the first half of June. We will be closely monitoring progress on vaccinations.

STRATEGY: Rates Lower +Higher yield ATH + VIX collapse are a Trifecta of positive signals for equity markets not seen for some time.

Equity markets are getting back into ‘half-full’ mode shaking off the Fed-tantrum last week. The announcement of significant progress toward a $1 trillion infrastructure plan is certainly a positive development. Financial markets appear to be providing some clarity on which direction they will take.

The US 10-yr is drifting lower and this means there is more upside to P/E and stocks can appreciate. There has also been a rally in High-yield bonds which continues to hover near all-time highs, we use HYG for proxy, and this senior asset class tends to lead stocks. The third positive catalyst we see for markets is that the VIX has dropped below $16. This generally causes hedge funds and other institutions to increase leverage, which is again more fuel for a rally in the market.

Nonetheless, I have followed markets for over 28 years and in the process developed a healthy respect for markets. More specifically I find three crucial principles investors should consider are the following:

1. Always be wary of financial markets and don’t shout at them (your stocks don’t know you own them)
2. Always be skeptical of consensus because much of what they are saying is likely already priced in.
3. Always use fundamentals as a crucial anchor. This will create a ballast during market tumult.

So, while the surface set-up is very positive, it’s possible we’re missing something. This positive setup hasn’t been seen for some time. For much of the past 18 months interest rates were rising and the VIX was stubbornly high in 2020. Generally, these three factors occurring seem to be a major “risk-on” signal to me, and it raises the probability that we hit 4,400 before month-end. Ok, maybe by mid-July, but still possible by month-end.

You might recall from our 2020 outlook that when the VIX normalizes (what is happening in 2021), the corresponding recovery in equities is unusually strong. For the past 17 years when the VIX level and term structure normalize from previously elevated levels, the S&P 500 gains an average of 23% over the next 12 months. This historical analysis of the VIX implies that 2021 could be tracking to be a year of 20% plus gains! Whoa!

Not only does the VIX normalizing bode well for the entire market, but it also bodes particularly well for Epicenter stocks. The historic relationship with VIX levels and the performance of Epicenter stocks shows Epicenter has led 84% of time in such cases. The median outperformance is about 3,200 bps.

Bottom Line: While a stretch, we still see the S&P 500 reaching 4,400 before month-end

It certainly seems to be a tall order for the S&P 500 to rally to 4,400 before month-end, but if precedent is to be believed, a sharp rally is likely underway. Energy remains our favorite sector. FAANG also benefits significantly from interest rate undershoot. We still are very favorable on Epicenter stocks.

Figure: Way forward ➜ What changes after COVID-19
Per FSInsight

Figure: FSInsight Portfolio Strategy Summary – Relative to S&P 500
** Performance is calculated since strategy introduction, 1/10/2019