Weekly Market Update (February 17 – February 21, 2020)

By Craig Fehr February 21, 2020

U.S. stocks were dragged lower by renewed fears of the global economic impact caused by the coronavirus outbreak. Apple lowered its revenue guidance on lower demand for its products in China amid temporary retail store closures, which added to worries about the fallout from a slowdown in China's economic growth. Positively, China cut its benchmark lending rates last week, lowering financing costs for businesses in an effort to support the economy. Preliminary economic data from IHS Markit showed that the U.S. services sectors contracted unexpectedly in February.  Activity in the manufacturing sectors also weakened. We expect to see increased short-term volatility in response to potentially underwhelming economic data and more profit warnings from companies in the first quarter. However, we don't think this will knock the economy off its expansionary path, as activity is likely to rebound as the year progresses.

Warning Signs?

It's said that you shouldn't look a gift horse in the mouth, but we'd argue that it doesn't hurt to check it for cavities occasionally. The stock market has certainly played the role of gift horse lately, returning over 4% so far this year and an average of 14% since early October, including reaching new all-time high last Wednesday1. We have no objections to this latest rally. The economic backdrop, monetary policy settings, and financial conditions are all supportive of further longevity for this bull market.

At present, we see no structural imbalances, bubbles or excesses (often hallmarks of a market top) that pose a systemic or imminent threat. But we are mindful that a root canal is what results when a small cavity goes untreated. To that end, we note below a few recent signs that have caught our eye. The upshot is that none of these are sufficiently structural that they are flashing red for the broader market outlook. However, they do reflect current sentiment that we'd characterize as an air of complacency. We think investors can maintain a positive outlook in 2020, but they should anticipate a bumpier path ahead.  

  1. Market reactions have been muted – No one is complaining that the stock market has been calm. Too often, in our view, the market overreacts to headlines and noise, temporarily ignoring the more important fundamental factors (these knee-jerk reactions are, to us, gift-wrapped opportunities for disciplined investors). But we also know that market swings are a normal and even healthy part of the bull-market process (think of it as pruning a shrub to help it grow). Moreover, we've seen historically that just as market overreactions don't last, market underreactions don't persist indefinitely either.
    • Since September, the market has risen on nearly two-thirds of all trading days – notably above the 20-year average ratio of up-to-down days2
    • In the past 12 months, there have only been four days in which the market has dropped by 2% or more, compared with an average of 16 days per year over the past 20 years2
    • It's been six months since the stock market experienced even a 5% pullback, and it's been more than a year since the last 10% correction2. This alone does not portend an imminent sell-off. In fact, the market went nearly four years (Oct. 2011 to Aug. 2015) without a 10% drop2. That said, even in that historic run, there were frequent smaller pullbacks.
    In addition, we think current market expectations may be somewhat misaligned with the potential impact from the coronavirus outbreak. As we've noted in recent weeks, we think the economic effects are likely to be material but temporary and won't be a catalyst for an outright recession. However, we do believe global GDP and U.S. corporate earnings growth estimates will need to be revised modestly lower, which could become a spark for temporary volatility this year.
    • The good news: Low volatility is more a precursor to a potential pickup in the magnitude of short-term fluctuations than a symptom of an ending bull market. With positive GDP growth, rising earnings, and supportive Fed policy all likely to remain in place this year, we'd view knee-jerk market pullbacks as compelling buying opportunities. 
  2. Market leadership has narrowed – The largest five companies (by market capitalization) in the stock market now account for 18.1% of the S&P 500 index, above the long-term average of 12.5% and up sharply from 11% as recently as 20162. This catches our attention because it reflects a narrowing of leadership for the market, potentially making the S&P 500 Index more vulnerable to weakness if these top stocks were to stumble. Since 1990, the concentration of market cap for the top five stocks has only risen above 14% twice before – 1999 and 20082.

    The top five today is comprised of Microsoft, Apple, Amazon, Google and Facebook – in that order2.  For comparison, in 1999 the list was Microsoft, GE, Cisco, Walmart, and Exxon Mobil2. In 2008 it was Exxon Mobil, Procter & Gamble, GE, AT&T and Johnson & Johnson2. The shifts are largely emblematic of the economic evolution that has occurred over the last two decades, with today's technology concentration (versus industrial and consumer names in the past) reflecting not only the tremendous performance of these companies, but also the significantly larger and more diversified contribution of the technology sector to current U.S. GDP.
    • The good news: The S&P 500 is a capitalization-weighted index, so, by definition, the largest companies are going to exert the greatest influence on overall stock-market performance.  Thus, the sharp gains in these five tech giants have not only vaulted them to the top five but have also made them responsible for a decent portion of the stock market's recent strong gains.  Again, this alone is not a signal of approaching doom for the market. In 1999, it wasn't the P/E ratios of GE, Walmart and Exxon that were responsible for the excessive tech-bubble valuations, nor was the size of P&G, AT&T, J&J and Exxon a signal of the brewing financial crisis in 2008. While weakness in these tech giants' stocks would present a headwind to the index performance, we think the strong gains and leadership of this group are indicative of today's healthy economic environment and ample growth prospects that lie ahead. 
  3. Pockets of exuberance – While tightening monetary policy has historically been a trigger for recessions and bear markets, bubbles and/or market imbalances have also been a signal of market tops – the U.S. housing bubble and the tech bubble being recent examples. Excessive optimism, investor euphoria and unsustainable price increases are traditionally hallmarks of such bubbles.

    We don't see these conditions in place today, but the recent performance of Tesla's stock caught our attention as an example of where this type of optimism may be showing up. Tesla shares are up 115% since January 1 and have risen more than 250% since late October1. To be clear, this is not an assessment or recommendation on Tesla's stock (Edward Jones does not cover or have a rating on Tesla shares). Instead, it reminds us of prior instances when investor excitement manifested in certain assets. In 2017, bitcoin rallied 450% in a span of a few months (it subsequently fell 62% in even less time)1.  Around that same time, cannabis stocks experienced an incredibly sharp rise as investor excitement skyrocketed. This occurred at the tail end of 2017 – a tremendous year in which the market rose more than 20% and didn’t endure even a 3% pullback for the year1. The market subsequently took a breather in early 2018, pulling back in February before resuming its trek higher for much of the remainder of the year.
    • The good news: We monitor the relative performance of the defensive areas of the market compared with the more cyclical areas, which provides us one gauge of investor sentiment. Currently, this measure shows us that there is not an excessive amount of optimism, even as the market has ascended to new highs. Near-parabolic increases in specific assets (such as Tesla shares recently) draw our eye, but we're also watching for this sense of euphoria or uninterrupted momentum to become pervasive across the market and be a signal that investors should be more concerned about the prospects for equities. 

Craig Fehr, CFA
Investment Strategist

Sources: 1. Bloomberg 2. FactSet

Index Close Week YTD
Dow Jones Industrial Average 28,992 -1.4% 1.6%
S&P 500 Index 3,338 -1.3% 3.3%
NASDAQ 9,557

-1.6%

6.7%

MSCI EAFE 2,003 -1.3% -1.7%
10-yr Treasury Yield 1.46% -0.1% -0.5%
Oil ($/bbl) $53.33 2.5% -12.7%

Bonds

$114.92 0.5% 2.3%
Source: Morningstar, 02/24/2020.  Bonds represented by the iShares Core U.S. Aggregate Bond ETF. Past performance does not guarantee future results.

The Week Ahead

Important economic data being released include consumer confidence on Tuesday, new home sales on Wednesday, and personal income and spending on Friday.

Review last week's weekly market update.

Important Information

The Weekly Market Update is published every Friday, after market close.

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The content of this report is for informational purposes only and should not be interpreted as specific investment advice. Investors should make investment decisions based on their unique investment objectives and financial situation. While the information is believed to be accurate, it is not guaranteed and is subject to change without notice.

The Dow Jones Indexes are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use.

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