A Sloppy Summer for Stocks Is Going to Test Your Stomach

(Bloomberg Businessweek) -- Perhaps, in retrospect, it was foolish to ever think of the world in black-and-white terms during the age of Covid-19. Yet that’s the trap so many of us fell into, whether corner-suite executives planning a workforce’s return, decision makers in government, or investors trying to get in front of wherever the markets decide to go next.

The scintillating vision of the dark era of Covid lockdowns quickly giving way to a bright, vaccinated future was simply too enticing to resist. But, at the moment, a much-less-satisfying reality is settling in: a sort of gray area between full recovery and the lockdown-era doldrums as the virus stages a fresh assault on the unvaccinated, and its relentless mutations raise questions even for those who’ve gotten their shots.

Consider the mixed messages in the past week as the midway point approaches for a summer heralded as the start of a new roaring ‘20s, at least in the U.S. and much of Europe. Britain celebrated the easing of Covid restrictions on July 19 in what was branded “Freedom Day.” Yet its prime minister was locked up in quarantine, and U.S. officials issued a stern warning for Americans to stay away from the U.K. because the virus was raging there again. Los Angeles reinstated indoor mask mandates, while New York declined to do the same. As “back to school” signs began popping up at stores, Apple Inc. pushed back its deadline for employees to return to the office. In Tokyo, the buzz is about which Olympic athletes have caught the virus instead of which ones will wear the most medals.

For those who trust the alleged wisdom of crowds in the financial markets, the picture is foggy. Benchmark indexes took a dip in the middle of July, though they got a partial rebound with a strong rally on July 20. Even before that, share prices had been slumping for companies expected to reap the biggest windfalls from a post-Covid boom—and not just for the likes of airlines, cruise lines, and hotel companies, but also for banks, energy producers, and wide swaths of the small-cap market. Unprofitable companies—stocks that are popular when the appetite for speculative, risky investments is strong—have been among the worst hit.

The prognosis from the bond market arguably has been even more worrying for equity investors seeking a second opinion. Early in the year, as optimism spread that vaccines would unleash bottled-up consumer savings and demand to create a prolonged expansion, investors sold off the safest of assets such as Treasuries, pushing the yield on the 10-year note up to 1.74% by the end of March. Yet they’ve been returning to that haven ever since, bidding bond prices back up and dragging the yield back down closer to 1%. In general, booming bond markets are a sign of pessimism.

“Obviously the bond markets are suggesting to us that there’s some weakness in growth, and that is linked to the delta variant” of the coronavirus, Katie Koch, co-head of fundamental equities at Goldman Sachs Asset Management, told Bloomberg TV on July 20. Yet to her and many of her peers, the signals being sent by corporate America are more positive and stronger than the bond market’s. As second-quarter earnings start trickling in—with about one-tenth of the companies in the S&P 500 reporting results so far—the early read is encouraging: More than 86% of the companies that have reported have beaten analyst estimates, and profit growth is clocking in at a breathtaking 141%, according to Bloomberg data.

Still, that growth compares to the second quarter of 2020, when Covid’s grip on the economy was tightest. But to Koch and many of her peers, just because the results will probably mark the recovery’s peak, there’s no reason to give up on equities now. Although the growth that’s to follow will be less dazzling, it’s still significant. S&P 500 companies are forecast to boost profits by more than 10% in both 2022 and 2023, according to analyst estimates compiled by Bloomberg.

Digging deeper into the signals being sent by financial markets, there aren’t yet any major warning signs to suggest that the delta variant—or whatever mutations might follow—will be enough to snuff out the recovery. Economic models based on market inputs show that the chance of another recession in the near future is very slim. A model created by Bloomberg strategist Cameron Crise puts the probability of recession in the next 12 months at just 7%.

Frothy valuations do give many fundamentally minded investors reason for caution. And the gray area of the post-Covid world is engulfing the playing field when it comes to both monetary stimulus from the Federal Reserve and fiscal spending stimulus from Congress—the two forces that brought the economy and the markets back from the brink last year. The pickup in short-term inflation has been stronger than many expected, and provides talking points to argue against further stimulus for both Fed policymakers and politicians launching midterm-election campaigns in the coming months. (How severe a threat the delta variant poses to those talking points is anyone’s guess.)

Undeniably, investors’ buy-the-dip instinct—honed by the experience of 2020—appears to be as alive as ever. The July 20 rebound echoed one that followed a similar episode of jitters in June. That shouldn’t be too surprising, given how much cash American consumers and businesses have socked away in the past 16 months. The personal savings rate in the U.S. averaged less than 7.5% in the five years before Covid hit. After surging to as high as 33.7% in April 2020, it’s still elevated at 12.4%. Before the pandemic, it hadn’t been that high since the early 1980s. Some $4.5 trillion remains stowed away in money market mutual funds, earning basically nothing. That amount has come down from its peak, but is still about one-quarter higher than before the pandemic. Another $17 trillion is on deposit with commercial banks, a record amount that’s 33% higher than at the same time of year in 2019.

Where will all that cash get spent? Will there be splurges on airfare and hotels and gasoline for road trips? New return-to-work business attire in a larger size to accommodate waistlines that grew a bit during the pandemic? Or will the re-emerging Covid threat mean it’s spent once again on sweatpants, Amazon impulse buys, streaming services, and maybe some furniture for the home office? For corporations, will their cash be put toward share buybacks, acquisitions, and research and development? Or used to keep the lights on in another dark period of Covid?

The closely followed strategists at JPMorgan Chase, led by Marko Kolanovic, say the market has overreacted to the threat of the delta variant. They argue that the latest flare-up of the virus should not lead to a return to lockdowns; while the rise in cases is alarming, vaccinations have sharply cut the threat of death from the virus. And this should lead to a rebound in stocks that benefit from the reopening amid continued inflation and higher bond yields.

For the non-pros, however, the sloppy summer market action provides a perfect time to reflect on the evergreen advice that diversification is the best way to avoid the heartburn that accompanies attempts to pick stocks that will beat the market. In other words: Just leave it in the index fund and enjoy what’s left of the summer.
 
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