Markets vs. the Real Economy

Sapient Investment Committee

November 24, 2020

The year 2020 continues to deliver surprises to investors and increased volatility to the markets. We know it can be challenging to discern truly meaningful news amidst all the media noise out there, but we believe the three Q & A topics below are important and timely for you.

1. What are Sapient’s thoughts about the outcome of the recent election and its potential impact on markets?

Although the presidential election results are still being contested, the most likely outcome appears to be a divided government. Under this scenario, we believe major tax increases, which might have been anticipated under a “Blue Wave” whereby Democrats would control the White House, Senate, and House of Representatives, are likely off the table for at least the next two years.[1] It appears to us that both Republicans and Democrats remain interested in some level of additional fiscal stimulus in the $1 trillion range, as well as meaningful infrastructure spending and drug pricing reforms, so we feel progress on those fronts is likely.

Stepping back and utilizing a broader lens, elections have historically been less important for capital markets than some investors might assume. Even under a divided government market returns have generally been positive, as illustrated in the graphic below.[2] As long-term investors here at Sapient, we remain optimistic about the future of our country, economy, and markets for the next four years and beyond. We consider it unwise to bet against American innovation and ingenuity even during the most challenging times.

2. Is it surprising that equity markets are setting new record highs this month while the underlying economy struggles to find solid footing?

On the surface, there has been a seeming disconnect between the market and the real economy in 2020. We’ve watched the S&P 500 rise more than 40% from its March 23rd lows through the end of October, posting a 2.8% gain year-to-date[3]; meanwhile, the underlying economy has struggled with GDP at the end of Q3 still 3.5% below where it ended 2019[4] and unemployment still nearly double its rate in February.[5]

Generally, the markets and the underlying economy are more in sync with one another than they have been these past 7 months.[6] However, this unusual year also serves as a good reminder that markets are forward-looking, and to us it appeared markets were relatively quick to price in the Q2 collapse in GDP and corporate earnings as short-lived phenomenon driven by global lockdown measures. During the recovery, stock valuations soared to even higher levels as a result of the Federal Reserve’s newly re-imposed zero interest rate environment.[7] Arguably the most defining feature of this stock market recovery has been its narrowness. Through the end of October, all of the S&P 500’s year-to-date gains, and then some, have been captured by the five largest companies – Apple, Microsoft, Amazon, Facebook, and Alphabet (aka Google) – which were up a collective 41.8% for the year, while the other 495 companies in the S&P 500 were down a collective 3.8%.[8] This disparity is what is known in investment parlance as a “narrow” market recovery, and it has resulted in what is now the most concentrated, top-heavy market of the past four decades. The top 5 companies represent approximately 23% of the S&P 500 index value compared to the long-term average of 12%.[9] This unequal recovery, coupled with valuation levels which seem stretched, suggests to us that markets remain fragile and, as a result, we’ve kept portfolios positioned conservatively.

3. How important is ongoing stimulus and support from the Federal Government and Federal Reserve?

We believe the U.S. economy still needs help getting back on its feet. Swift stimulus efforts from both the Federal Government and the Federal Reserve in the early days of this crisis helped cushion the initial economic blow from the virus and related lockdowns. However, Chairman Jerome Powell has communicated in recent months that the Federal Reserve has largely exhausted the tools at their disposal to help stimulate the economy, and significant further support from the Federal Government is critical to continued economic recovery in the coming months.[10] Chairman Powell has been transparent in his communications to assure market participants the Federal Reserve’s policies will remain accommodative for the foreseeable future, including plans to keep interest rates at or near zero until at least 2023.[11] The Legislative branch of government we feel, however, should lead the charge from here. It is far from certain how successful a seemingly divided Congress will be at finding compromises both sides can live with. The capital markets appear to be focused on the next round of fiscal stimulus talks, particularly in light of the near term rise in Covid-19 cases and declining business continuity nationwide. We believe the markets could move sharply up or down in the months ahead depending on the outcome of these negotiations.

Thank you for allowing us to serve you and steward your investment capital with great care.

6. Cypress Capital, Market Outlook, October 23, 2020

Although the statements of fact and data in this report have been obtained from, and are based upon, sources that the firm believes to be reliable, we do not guarantee their accuracy, and any such information may be incomplete or condensed. All opinions included in this report constitutes the Firm’s judgment as of the date of this report and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. Past performance is not a guarantee of future results.

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