Q2 2020 Market Update

August 12, 2020

· Quarterly Market Recap

· Election Fears

· Market Fragmentation

· Top Client Questions and Answers

Quarterly Market Recap

The second quarter saw a large rebound from the shutdown lows. The Wilshire 5000 gained 22.13% from 03/31/20 to 6/30/20. As of 6/30/2020 the Wilshire 5000 remained slightly down for the year at -3.82% (1).

The Aggregate Bond market, as measured by the Barclays Aggregate Bond Index, gained 2.46% in the second quarter. As of 6/30/2020, the Aggregate Bond Index has moved up 5.20% in price return for the year (2).

Both the stock and bond markets showed extreme stress for most of March as the country faced the onset of economic turmoil induced by the Covid-19 pandemic. Since the lows, the stock market has rallied upward over 40%, showing strong resilience in the face of tough economic conditions.

Accounts have weathered the storm as expected with most approaching break-even for the year. We are very pleased to see accounts getting back to more normal levels and remaining in line with long term planning objectives.

Election Fears

We understand this is an area of great concern for many of you. We know this is top of mind and we will work to share some thoughts the next couple months. We feel it deserves a full article all to itself!

Market Remains Fragmented

The stock markets remain highly fragmented with a diverse set of returns rarely seen in my career. Take a look at some standard index returns to get an idea about the current fragmentation:

*As of quarter end 06/30/2020 (1)

Nasdaq Composite: +12.11%

Russell 1000 Growth: +9.18%

S&P 500: -4.04%

Dow Jones: -9.55%

S&P 500 Equal Weight Index: -12.06%

Russell 1000 Value: -17.48%

Dow Jones US Select Dividend: -23.45%

In short, the market is reflecting 2 separate economies. We have both a DIGITAL ECONOMY and a HANDS-ON ECONOMY. When Covid-19 hit and created the environment for shutdowns, a clear line was drawn in the sand. Companies that benefit from the digital economy were in a position to thrive during the shutdowns while companies reliant on hands-on efforts would falter. Companies like Amazon, Facebook, Netflix, Shopify, Paypal, Microsoft, Apple to name a few would be able to capitalize while companies like Boeing, Coca-Cola, Starbucks, Disney will take a bit longer to get back to complete normalcy. This trend of business and consumers operating within the digital economy is not something new, but the shutdowns essentially forced 3 years’ worth of transition into 3 months. Consumers were greatly influenced to utilize Amazon for more shopping. Businesses were forced to figure out digital payment platforms such as Paypal to keep products moving. Everywhere you looked, companies had to adjust. From Zoom Communications hosting record conference calls to the record data being migrated into the cloud…the examples of our exploding digital economy are now endless.

Not surprisingly, the index examples above that hold more digital economy companies did better compared to an index that held more hands-on economy companies. The more concentration you have in the digital economy, the better you performed. Thankfully we have been fairly balanced and accounts are again near positive territory and hopefully can get back to highwater marks very soon. Over time we would expect the hands-on economy to also fully recover and would not be surprised to see some of the solid companies that have lagged this year start to lead the next wave up as the recovery continues to balance out.

Are we in a Bubble?

No, not yet anyway. The earnings from many of the largest companies that make up the market have been fantastic and support the rebound thus far. We do expect some companies within the digital economy to enter bubble territory. This is to say, we expect some “over-exuberance” with unsustainable stock prices and unrealistic profit expectations. Similar to the dot com bubble of the late ’90s, we see an environment that could lead some stocks to experience massive declines that will take years to recover. Our discipline of owning more stable companies with a track record of profits should help us avoid this euphoria. Hopefully, any extreme bubble will remain in more select areas of the market and not become a systemic issue. This is certainly something we are watching closely!

How is the market almost back to break even while so much of the economy is struggling?

The market is not the economy but rather a reflection about the current and future expected profits for the companies it represents. Of course, the economy can impact the companies, but the companies themselves have a much bigger impact on market price than economic activity.

If you look at the S&P 500, you will find that 12 of the top 25 companies operate in the digital economy. These 12 make up a huge percentage of the overall S&P 500 at around 30%. These companies are Apple, Microsoft, Amazon, Facebook, Google, Visa, Mastercard, Nividia, Paypal, Netflix, and Adobe. Year to date these 12 companies have averaged 41.65% at the quarter-end. The remaining 493 companies within the S&P 500 averaged -10.65% (yes, it’s 493 because there are 505 total companies). So when you look around and see many businesses struggling, it is important to realize that for every dollar they are losing we are seeing that dollar added to the digital economy and reflected in rather large gains for parts of the market.

How could the market possibly go up from this level?

We try not to presume upon the future. We find it much healthier to make good decisions in the context of current data, a good plan, and stay the course. This year has proven our philosophy a wise move. With massive injections of liquidity and stimulus into the economy by the government (Fiscal and Monetary) we expected to see a solid rebound from the March lows. If we see the Federal reserve continue to inject liquidity and remain focused on 0 rate policy for the long term then it seems the wind is at our backs for more price increases. The Federal Reserve has made clear that they are willing to forgo years of target inflation policy to get the economy humming again. This is a major change from the past 10 years and warrants a deeper study on our part. Low-interest rates in combination with a vaccine and/or reduced virus fear could very easily cause a continued market increase. We still see large amounts of money on the sidelines waiting for clarity. If we see the virus worry start to decline by year-end then it would be very possible to end the year with a reasonable return.

What could cause a second major decline?

Systemic business shutdowns. If the fear causes more constraint and shutdowns this year, then we could see a reversal in the market. This would be a deadly blow that would likely cause a retest of the March lows.

Looking out a bit further, a massive inflation spike could also prove problematic.

Given government spending, has your view on inflation changed?

We mentioned in a prior article the long-term hazard of inflation. Whenever things are really good you must be aware of inflation. It is hard to imagine we won’t have above 2% inflation at some point, but ultimately the FED has many tools to control. We will keep a close eye on inflation as the economy rebounds. It has already factored into our asset selection and favors capital-light investment that generally has larger margins and a higher return on capital employed. We are keenly aware of the danger’s inflation can unleash on a portfolio. Nothing has stolen more money than inflation. Not taxes or government regulations have compared to the dangers of out of control inflation and we hope the government and FED can properly rein in spending after a full economic recovery has taken place.

MY FAVORITE QUESTION – What makes your head spin at night? – follow up from last quarter

Last quarter I stated that the idea of long term 0 or negative rates combined with a government inflation target is a very interesting and “new wind” for the market. I can not figure out if this is a tailwind or a headwind.

The FED answered my question by changing its position on-target inflation. They will no longer hold a hard target of 2% inflation. This makes much more sense to me because I could see no world where you could control inflation with rates held near 0 for an extended time.

This likely validates our conclusion. Stocks need to be a large part of your portfolio to maintain real purchasing power. We struggle to see how fixed income products such as bonds at 2-3% can offer any real return when inflation is now being targeted at OVER 2%. It could be a slow draining tub for portfolios that have extreme fixed income long term. Of course, this thought process is exactly what could also lead to large volatility in the equities markets. The next 10 years may prove much choppier than the last 10. To manage the volatility with higher confidence we continue to feel high-quality companies …high quality balance sheets will drive a premium and be very important in years to come.

“Stock market looks high, is high, but not as high as it looks.” – Famous Benjamin Graham Quote

“Our acquisition preferences run toward businesses that generate cash, not those that consume it. As inflation intensifies, more and more companies find that they must spend all funds they generate internally just to maintain their existing physical volume of business. There is a certain mirage-like quality to such operations. However attractive the earnings numbers, we remain leery of businesses that never seem able to convert such pretty numbers into no-strings-attached cash.” – Warren Buffet

We hope this article adds some value, answers some questions, and perhaps gives you a little extra peace during this unique period in history!

It is a tremendous honor to help steward your assets and retirement journey during this time. Thank you for your trust! Please reach out if you have any questions. You and your families remain in our prayers as we move through this time together.

(1) Data reported by Folio Institutional. (2) Data reported by Y-Charts Data, www.ycharts.com .

Index results such as the Wilshire 5000 and S&P 500 do not reflect management fees and expenses and you cannot typically invest in an index. Evergreen Wealth Management, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.