The COVID-19 pandemic has allowed many of us to catch up on shows that we’ve been meaning to watch. Over the last three months, as of the end of April, Netflix more than doubled the number of new subscribers it expected — more people signed up during the coronavirus pandemic. The streaming giant added 15.77 million new paid subscribers globally, well above the 7 million it expected, as people worldwide looked for ways to entertain themselves during the lockdowns.
My wife and I started The Sopranos after multiple recommendations. In one episode, Tony Soprano, the lead protagonist was trying to draw parallels between the experiences of the Cosa Nostra of the past to that of his own. He finishes the scene by saying, “If you don’t understand history, you can’t learn from it.”
From the all-time high on February 19 to the most recent trough on March 23, the S&P 500 fell approximately 34% in only 23 trading days. As of June 5, the S&P 500 has skyrocketed nearly 43%, leaving it only 6% off its all-time high. Investors have been asking, “Were the lows in this current cycle set on March 23?” While it’s extremely difficult to accurately answer this question, could past experiences during recessions help paint a clearer picture?
*** We looked at the one-year forward performance versus the S&P 500 for the following: Global Industry Classification Standard (GICS) level 1 indices, defensive sectors vs cyclical sectors, GICS sub-sectors (including homebuilders, lumber, auto and components, banks, insurance companies, airlines, road and rail, semi-conductors, and chemicals), individual companies that are cyclically sensitive (e.g., Caterpillar Banks, BHP Billiton), and the Russell 3000 Value Index against the Russell 3000 Growth Index.
The team looked back at the one-year forward performance of the S&P 500 GICS sectors, GICS sub-sectors, and other financial measures from their troughs that occurred during prior recessions. These periods include the global financial crisis (GFC), the dot-com bubble burst, and the 1990 recession. Below, we highlight the 5 Truths that we found to be consistent in the past and compare them to market performance today.
Truth #1: Cyclical sectors > defensive sectors
Cyclical companies typically follow the trends in the overall economy; when the economy grows, prices for cyclical stocks generally increase. Their fortunes typically follow the cycles of the economy from expansion, peak, and recession all the way back to recovery (for example, car companies). Non-cyclical stocks typically outperform the market when economic growth slows. Non-cyclical companies are generally profitable regardless of economic trends because they produce or distribute goods and services we always need, including things like food, power, water, and gas.
For the S&P 500, cyclical sectors include consumer discretionary, financials, industrials, information technology, and materials. The defensive sectors include consumer staples, energy, healthcare, telecommunication services, and utilities.
As the chart shows, over the previous three recessions, cyclical sectors materially outperform defensive sectors from the bottom of the market. Today, we’re three months into the recovery and the same relationship has held, cyclicals have outperformed defensive. As of June 5, the median cyclical return from the trough has been 48%, while defensives have returned 36%. The outperformance of the cyclical sectors would have been higher if not for the very strong performance by the energy and healthcare sectors within the defensive bucket.
Truth #2: Financials outperform the broader market
The backbone of any economy is its financial system. Banks play an important role in the economy, in part by offering loans to businesses that want to invest and expand. These loans and business investments are important for enabling economic growth. Markets are forward-looking, and the seedlings of an economic recovery are often rooted in the financial sector.
A strong economy leads to an increase in wages and asset price levels, causing higher inflation. Central banks respond with higher interest rates, often leading to a steepening of the yield curve. This environment is profitable for the banks and their historical stock performance from troughs highlight it.
In the United States, the financial sector includes both banks and insurance companies. As the chart below shows, the performance of the financial sector during previous recessions (GFC, dot-com, and 1990) has substantially outperformed the broader index. Looking underneath the hood of the financial sector, the chart shows that banks have outperformed their insurance company peers.
Today, the financial sector has risen by 48% from the trough, while the S&P 500 is up 43%. This truth was the slowest to develop. Up until 10 days ago, the financial sector lagged the overall index. However, the seven trading days ending on June 5 saw the financial sector up 12% vs the S&P 500 increase of 5%. Unlike the past, insurance companies have performed in line with their banking peers.
Truth #3: Homebuilders rip out of the gates
The performance of homebuilders in the United States is a good barometer for the health of the U.S. consumer. In an economy that drives nearly three-quarters of its output from consumption, housing is a great indicator due to housing’s wealth effect on consumption. In a recession, economic output contracts, unemployment increases, wages fall, and consumption decreases. The opposite is true as we come out of a recession, and homebuilders are often first out of the gate.
According to Zillow, a real estate database company, people spend big money not only on their homes but also on what goes in them, which means that housing data can be a leading indicator of economic activity months in advance. The total value of the U.S. housing market in 2018 was US$33.3 trillion. According to the National Association of Home Builders, the housing market represents about 15 per cent to 18 per cent of U.S. GDP. Said differently, a weak or strong housing market can have substantial influence on the direction of the overall economy.
In the United Sates, the S&P Homebuilders Select Industry Index includes D.R. Horton; Lennar Corporation; NVR, Inc.; and PulteGroup. As the chart below shows, the performance of homebuilders during previous recessions (GFC, dot-com, and 1990) substantially outperformed the broader index. During the current period, this same relationship has held up. As of June 5, the homebuilder sector is up 93%, more than doubling the S&P 500 return of 43%. What’s interesting to note though is there’s no clear-cut relationship with the price of lumber coming out of a market trough.
Truth #4: Value regains its luster vs growth
We looked at the performance of the Russell 3000 Value Index vs the Russell 3000 Growth Index to see if a certain style of investing performs better from the trough of the market. The Russell 3000 Growth Index is a market capitalization weighted index, based on the Russell 3000 Index, representing both large and small cap growth companies. On the other hand, the Russell 3000 Value Index is a market-capitalization weighted equity index that measures how U.S. stocks in the value segment perform. Included in the Russell 3000 Value Index are stocks from the Russell 3000 Index with lower price-to-book ratios and lower expected growth rates.
The data set is limited as the Russell indices are new, but they did exist during dot-com and the GFC, and in those periods, value outperformed growth. This time around, there’s no clear leader. Growth has returned 45% vs value’s return of 44%. Like banks, value made a comeback over the past seven trading days. The Russell 3000 Value Index was up 7.7% over the past seven trading days, with the Russell 3000 Growth Index up 3.4%. Of the truths, this historical relationship is one we have the least amount of confidence in. We believe value and growth investing has become a very lazy categorization of investing and hasn’t evolved to reflect today’s world.
Truth #5: Retail flows are a great contrarian indicator
The results of research done by Dalbar, Inc., a company that studies investor behavior and analyzes investor market returns, consistently show that the average investor earns below-average returns. For the twenty years ending December 31, 2015, the S&P 500 Index averaged 9.85% a year. The average equity fund investor earned a market return of only 5.19%.
Why is this? Investor behavior is irrational and often driven by emotion, leading to poor investment decisions.
In March 2020, the Canadian mutual fund industry had its worst month ever, in dollar terms, as it saw more than $14.1 billion in net redemptions, or the equivalent of 83 per cent of its total net sales in all of 2019. Subsequently, the S&P 500 rallied nearly 43% from the most recent trough set on March 23, 2020.
In the chart below, the grey line is the total equity and hybrid exchange-traded funds (ETFs) and mutual fund outflows. The black diamonds are the troughs set during each bear market dating back to 1998. Positive one-year forward returns are denoted by green shading while red indicates a negative one-year forward return. As you can see, retail investors have an uncanny ability to withdrawal large amounts of capital near troughs during bear markets and subsequently miss out on the rally afterwards.
Historically, retail capitulation is a good indication of a trough, with the exception being the GFC saw peak outflows during October 2008 of $87 billion dollars while the trough eventually happened in March 2009. However, even after the peak in outflows, retail outflows remained strong at nearly $100 billion dollars after October until the eventual trough was reached.
During the current sell-off and subsequent rally, those investors who were disciplined and stuck with their asset allocation have seen their portfolios regain most of the losses. However, those who succumbed to fear and panicked, losing their long-term focus, locked in those losses.
After looking at the performance from the trough of several GICS level 1 indices, sub-sector indices, and companies, there were five relationships that occurred consistently:
- Cyclical sectors outperformed defensive sectors.
- Financials outperformed the broader index.
- Homebuilders strongly outperformed the broader index.
- Value investing did better than growth investing.
- Peak retail outflows typically happen near troughs.
During the current equity market recovery, each of these five truths have occurred to some degree. But how important is it whether March 23 was the low?
During the GFC, the low for the S&P 500 Index reached in October 2008 was ultimately taken out five months later, on March 9, 2009. During the dot-com crash, while the Index reached its bear market bottom in October 2002, it was retested a year later. If March 23 was, in fact, the bear market bottom, it doesn’t preclude additional downside risk and volatility going forward.
Historically, the bottoming period during a recession is several quarters, not several months or several days, and we believe this time is no different. This market is likely exhibiting a two steps forward, one step back process as we slowly open up our economies, as we receive vaccine trial results, and as we get more details surrounding the potential for another round of trade disputes between the United States and China. Developments from each of these risks may serve as catalysts both to the upside and downside over the coming quarters.
In the meantime, we continue to believe the price of the market has gotten ahead of the fundamentals of the market. There’s a risk that the markets may be left disappointed with the pace of the economic recovery in the coming months. And therefore, our message remains the same. It has been the same message that we’ve been communicating for the past couple of months. Remove emotion from decision making, continue to be disciplined with respect to asset allocation, take the opportunity to rebalance portfolios, and take advantage of price dislocations. Don’t sell quality investments at a loss during sell-offs and utilize a dollar-cost averaging strategy over the next 6–12 months to take advantage of potential further upside while mitigating any downside risks.
Macan Nia, CFA
Senior Investment Strategist
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