This is a chart of the S&P 500 over the last five years.

(Source: Bloomberg)

Despite the market being down 12% this year and 16% from its high, many investors feel that this level of decline reflects a far too optimistic outlook given what is going on with the economy due to Coronavirus.

In this post we will offer some context that suggests the market is not nearly as optimistic as it might appear. But do not interpret this post as us saying that current market levels are justified or that the recovery will hold. Dramatic rallies such as the 27% move in the market over the past month have often occurred in the midst of multiyear bear markets.

The most important thing to keep in mind is that S&P 500 is often referred to as “the market,” but of course the S&P 500 is essentially the 500 largest companies in the US, which, especially during this crisis, are not indicative of the economy as a whole. And the largest 25 companies make up nearly 40% of the S&P 500. Here is a list of those companies:

Apple, Microsoft, Google, Facebook, Berkshire Hathaway, AT&T, Johnson & Johnson, Intel, Verizon, JP Morgan, Amazon, United Health, Pfizer, Bristol Myers, Merck, AbbVie, Bank of America, Proctor & Gamble, Cisco, Comcast, Visa, Home Depot, IBM, CVS, Amgen.

Now whatever you think about those companies, most all investors would agree that they are far, far more likely to survive this crisis than the average company. And, in fact, with so many smaller companies struggling it seems very likely that many of these large companies will thrive in a post-Coronavirus world in which their competition has been dealt a huge setback.

So looked at this way, the fact that the S&P 500 is only down 16% from its highs does not suggest that the market thinks the economy will be OK, but rather that the largest companies in the world will see their way though, and as demand returns they will face much less competition.

If instead, the market was reflecting investors being naively optimistic about the economic impact of Coronavirus, then you would expect to see economically sensitive stocks leading the recovery. But the reverse is true.

In this chart from Evercore ISI, you can see that over the past month the best performing segments of the market have primarily been more defensive stocks and those that benefit from low interest rates. While energy stocks have rebounded the most over the last month, it is still the worst performing sector so far this year.

(Source: Evercore ISI)

If investors were really expecting a quick economic recovery, then we would be seeing firms with weaker balance sheets performing well during this rally. But again, the opposite is true as this chart from Goldman Sachs illustrates how the companies with the best balance sheets, protection against economic weakness, are outperforming.

When investors collectively have an optimistic economic outlook, they tend to bid up the price of smaller companies. While smaller companies have more growth potential, they often lack the balance sheets or market dominating competitive positioning to thrive during recessions. And, we can see this concern from investors in this five-year chart of the S&P 600 Small Cap Index.

(Source: Bloomberg)

Not only is the S&P 600 Small Cap Index still down 31% from its high, it is trading at levels first reached in 2015. While the S&P 500 Large Cap Index has seen 0% returns over the past two years, the S&P 600 Small Cap index has seen 0% returns over five years.

We don’t know if the market is fairly valued today. We’re surprised that the market has rallied back so sharply, even before Coronavirus shutdowns have ended in the US. In our March 18^th blog post about Coronavirus we noted that the Chinese equity market had begun rallying the day after the shutdowns were implemented in Wuhan and fully recovered all its losses, until it later became clear that the outbreak would spread globally. But while we had seen what happened in China, we wrote at the time, “now to be clear, we are not suggesting we think the decline in the US stock market will reverse over the next month.”

The recovery in the S&P 500 is unexpected. Big rallies, just like big selloffs, are always unexpected. This doesn’t mean it will last. But nor does this rally appear to signal that investors have become irrationally optimistic about the economy.

Instead, it appears this has been more of a “risk off rally” with investors rapidly selling the stocks of smaller companies, those with weaker balance sheets and those with economically sensitive business models, and piling into stocks of larger companies, with strong balance sheets and economically defensive business models.

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

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