Our last update was two weeks ago. Since then, stock market volatility has continued to slowly moderate. From the end of February through early April, the average week included 4 of 5 days in which major stock indices rose or fell by 2% or more. In contrast, over the last month, the average week experienced only 1 of 5 days in which stock indices rose or fell by 2% or more. Yes, these past two weeks since our last update included one day with a 900 point move in the Dow Jones Industrials, and six days with 300 to 500-point moves. But in only one day in each of these last two weeks did stock indices move 2% or more either way. Volatility remains higher than normal but has eased in May relative to the extreme levels of March and April.
Market volatility has improved but market valuation has not. By any of several measures, stock markets, especially with respect to large US stocks, are as expensive now as ever before. That may not be a surprise to many, knowing that stock indices are now only down modestly this year (blend stocks being down only 11.4% this year to date through Thursday) while recognizing that this year’s earnings estimates, for example, are surely down more than that. What may be less apparent is the degree to which markets have lately become extremely concentrated and bifurcated (or divergent).
Concentration here refers to the degree to which a few stocks have become a larger and larger part of the overall stock market. Historically, the percent of the overall market accounted for by the largest 5 stocks has averaged 13.5% and peaked out in the 18-19.5% range in 1980 and again in early 2000. Today, the largest 5 stocks account for about 20% of the S&P 500 Index, a 40-year concentration high.
Some of the largest stocks (here not limited to just the largest 5) have become a greater portion of the overall market by outperforming the other stocks. Some of that performance has been justified by growth in fundamentals, but as is typical given human nature, that success has bred overreaction and much of this outperformance and concentration has been a function of greatly expanding valuations within that group. You may think it matters little whether performance comes from fundamental growth or valuation expansion, but in fact it matters a lot: fundamental growth tends to be more durable whereas valuation expansion is fickle and fleeting, and historically has always been reversed over time.
That divergence or gap in valuation between the much beloved large “momentum” stocks and the unloved cheap stocks is as large today as has ever been measured. As recently as year-end, that gap was very large but not quite as large as that achieved in late 1999. Since then, year-to-date performance of the Russell 3000 Growth index has been +1.8% versus -19.9% for the Russell 3000 Value Index – an astounding 21.7% performance gap in less than 5 months!
While it is true that the overall market is very expensive, this gap implies a significant portion of the stock market is cheap. Bifurcated performance always results in bifurcated valuation, which in turn implies the likelihood of bifurcated performance going forward in the opposite direction, meaning, a reversal in the relative performance of value and growth stocks in the longer term. Valuation differences, even extreme as they are now, inform virtually nothing about short-term expectations, but tend to be quite meaningful over the next 5 and 10 years.
In summary: very high valuations for overall stock markets imply low long-term expected stock returns from this point forward. But extreme market concentration and valuation disparity is such that the market’s cheap stocks today are relatively cheaper than ever, implying much better expected returns going forward for that segment of the market, especially relative to today’s very low interest rates.
All the preceding pertains to markets, but this crisis is a 3-headed hydra encompassing a health crisis, an economic crisis, and a market crisis. On the health front, more than 100 vaccines are under development globally with 8 in human trials. One of those reported positive interim results in a very small, fast-tracked phase I trial Monday which garnered considerable attention. Phase II trials are to begin for that one in July, which is unusually rapid. If all works out according to the preliminary indications, that one hopes to have at least some availability of an approved vaccine for emergency use among high-risk individuals within 6 months. That is all encouraging, but very preliminary.
As to the economy, nearly every state is now embarking on some form of slow, phased reopening. With different local conditions, some have started a week or two ago, others are barely beginning now. And all are accompanied by concern that opening may accelerate spread of the virus. It is too soon to tell about that, even for the earliest states that relaxed mitigation measures, but Europe is encouraging in that regard. Europe entered this health crisis generally a couple of weeks before we did and has generally started reopening 2-4 weeks ago and has so far not seen reversal in their progress against the virus. So, there may be reason for cautious optimism regarding reopening which is the hinge for economic recovery.
The point is that these next 2-4 weeks define a period of exceptional uncertainty regarding the health crisis and consequently in the potential timing of a turn in the economic crisis (and obviously, for markets as well). We continue to take advantage of market dislocation and some newfound tax freedom to do swaps that either improve the valuation of portfolios or harvest tax benefits (or both). As we collectively embark on the Great Reopening experiment, let’s together hope events will allow us to defer our next update for a few weeks.