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By Pete Biebel, Senior Vice President

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For the past five weeks, the big question for the market has been whether the impressive rally from late-March into late-April was the beginning of a new bull market or just a rebound rally in a continuing downtrend. The rally extended far enough to convince many that the lows had been seen, but it failed to climb far enough to invalidate the continuing bear market theory.  Last week’s pullback wasn’t so damaging as to greatly increase the odds for a new low, but it was enough to instill a smidgeon of doubt in the minds of the newborn bulls.

Everybody knew that the COVID contagion would be very harmful to the health of the U.S. and global economies. The market’s reaction late in the first quarter of the year was its impulsive response to the realization that the economy would be taking a turn for the worse. No one knew how sick the economy might eventually become, but the initial sell- off probably was a bit of an overreaction. The first week or two of the rally out of that extreme oversold condition wasn’t a surprise, but the extension of the rally into late-April and early-May seemed to be giving economic conditions a clean bill of health.

The diagnosis from the market was that the economy would be certainly coming out of its coma. The data wasn’t and still isn’t looking too good, but all those numbers are lagging indicators. The rate of COVID infections internationally and domestically had leveled off and was beginning to decline. Fiscal and monetary policy provided emergency operations with the promise of more to come. Some states were even beginning to reopen select businesses. Surely, as businesses opened, the vital signs would begin to improve.  That was the basis for what was probably a little overly optimistic assessment. More recently, concerns over the speed and the effectiveness of some of the early re-openings along with more dire warnings from health officials have forced a reevaluation of the true health and recovery potential of the economy.

Following the spectacular gains in the previous week, last week’s relapse to losses was a disappointment. Reevaluations on two other key topics apparently contributed to the weakness. First, the renewed possibility of trade tensions between the U.S. and China weighed on the market’s optimism. Then, later in the week, comments from Fed Chair Powell that, “Asset prices remain vulnerable to significant price declines should the pandemic take an unexpected course, the economic fallout proves more adverse, or financial system strains reemerge,” added to the concern.

Big gains in technology and biotech stocks helped the NASDAQ Composite Index (COMP) reach a new recovery high on Monday, but that turned out to be its high for the week. The S&P 500 Index (SPX) just managed to breakeven on Monday and the Dow Jones Industrial Average (DJIA) lost about 0.5% for the day. Neither SPX nor DJIA were able to poke above their late-April highs on Monday’s rally. The reemergence of the China trade concerns on Tuesday and the Powell comments on Wednesday contributed to significant losses both days. Gains on Thursday and Friday recovered about half of the early-week losses. For the week, COMP lost a little over 1%; SPX lost about twice as much, and DJIA gave up 2.65%.

The midweek losses forced the optimists to reevaluate their “new bull market” theory. Then the late-week rally put a damper on any suddenly rejuvenated hopes of the bears.

The gold market continues to perform well. Other than long Treasuries, gold has the best year-to-date performance of just about any asset class. Gold gained about 2 ½% for the week and now is just 1% below its high of a month ago, which was its highest price level in more than seven years.  Among U.S. equities, only the Healthcare sector made it through the week with a gain, and it advanced just under 1%. The Energy sector, which had displayed some uncharacteristic vigor in recent weeks, saw that vitality fade last week.  That sector lost more than 7% for the week, the worst of the S&P industry sectors.

One of the most striking features of market action over the past few months has been the sharp contrast between the winners and the losers. The contagion has been crushing news for airlines, hotels and cruise lines. It’s been a godsend to social networking, video streaming and online shopping companies. Many technology and biotech firms have been among the big winners for obvious reasons. And, it’s been a lot easier to buy and hold stocks of large companies with strong balance sheets than to take a flyer on small, highly leveraged companies.

Generally speaking, large-caps have been the relative winners while small-caps have been the clear losers. Shares of technology-oriented companies have generally crushed the performance of more basic industrial and financial stocks. Only about 17% of the 2880 stocks in the Russell 3000 Index have a year-to-date gain.  The names on that winners’ list are dominated by biotech, pharmaceutical and technology companies. Fully 45% of the 103 stocks in the NASDAQ 100 Index have year-to-date gains. Only about 15% of the 1968 small-cap stocks in the Russell 2000 Index (RUT) can make that claim. The numbers over just the past three months are similar. Less than 13% of RUT’s component stocks have a positive total return over the past three months compared to a bit over 30% of the NASDAQ 100 stocks.

As a result of those biases in market action, the topic of “reconstitution” will soon be commanding the attention of market participants. The annual rebalancing of the Russell indices will occur next month.  Not only is that reconstitution likely to force record turnover, but it will also likely lead to movements in the affected stocks prior to the actual date of the change, June 26th.  That day could well be the highest volume day of the year.  All funds that track one of the Russell indices, both passive and active, will need to adjust their holdings to parallel the new line-ups. Because it’s far more likely that better performing stocks will be added to the indices and laggards will get the axe, the whole process is likely to exacerbate the dichotomy in performance between the strong and weak names.

The world’s most replicate index, the S&P 500, may also go through a significant reconstitution soon. The issue is how long the S&P committee will ride out the contagion before eliminating some of the COVID damaged names. Over the weekend, Bloomberg reported that DataTrek Research estimated that more than 30 stocks could be jettisoned from the index.  Considering the huge total invested in S&P tracking funds, a reconstitution of anywhere near that magnitude will be worth watching.

SPX broke below the 2900 level late Tuesday and continued lower to near the 2770 level Thursday morning. After rebounding Thursday and Friday, it ended the week near 2864. My guess is that, at best, any follow-through on last week’s late week strength could extend the rally into the 2870 – 2880 range on SPX this week. I suspect that the 2900 level will prove to be a significant barrier, but if SPX can climb back above that level in the next week or two, that would force some reevaluation.  If selling pressure resumes this week, the first level of concern would be near 2820.  Breaking below that level would greatly increase the odds of revisiting last week’s lows near 2770. As I wrote last week, “The real danger level for SPX is in the 2727 – 2730 range. That’s the area of the April 21st low and the index’s 50-day moving average. Sustained trading below that level would likely be a signal that the rebound rally has run its course.”

Though we’re well into the first quarter earnings season, reports from several major companies are due this week including about a half-dozen big retailers. At least for the time being, the worst for the U.S. economy has probably passed.  The consensus estimates for economic data later this week provide the first glimpses of possible improvement.

Date Report Previous Consensus
Monday 5/18/2020 Housing Market Index, May 30 33
Tuesday 5/19/2020 Housing Starts, April 1.216mm 0.968mm
Wednesday 5/20/2020 FOMC Meeting Minutes
Thursday 5/21/2020 Initial Jobless Claims 2,981K 2,375K
Philadelphia Fed Business Outlook Survey, May -56.6 -41.0
U.S. Manufacturing PMI Composite Flash, May 36.1 38.0
Existing Home Sales, April 5.270mm 4.325mm
Leading Indicators, April -6.7% -5.9%

 

Links to previously published commentaries can be found at benjaminfedwards.com/For Our Clients/Educational Resources/Market.

May 18, 2020 |