Market Update: August 4, 2020

Following on the heels of the strongest quarter since 1998, July was another blockbuster month for the S&P 500. The market delivered its strongest July performance since 2010 and one of the strongest we’ve seen in any July over the last 35 years (Figure 1).

This outstanding performance is notable for its timing as well as its balance. In what is typically a seasonally weak period, July’s S&P gain of 5.6% displayed consistent strength across the market, with all sectors except energy finishing positive for the month (Figure 2).

Figure 1. This was one of the strongest July performances in recent memory for the S&P 500.

Source: FactSet

Figure 2. Strong breadth, like that seen in July, is an important characteristic of a bullish market.

Source: FactSet

Three important points stand out in this market-wide rosy glow:

1. The technology sector finished in sixth place, coming in sharply below the respective returns of value-oriented sectors such as utilities, materials, and consumer staples.
2. Prior to the last day of the month—which brought strong earnings reports from Apple, Amazon, and Facebook—technology was only the tenth best sector for the month, with only poorly performing energy behind it (Figure 3).
3. Up until the last day of the month, six entire sectors had outperformed an equal-weighted basket of the FANMAG stocks (i.e., Facebook, Apple, Netflix, Microsoft, Amazon, Google), and four of those sectors have a Value tilt (Figure 4).

The bottom line here is that, apart from the final day of July, the market strength was most definitely not solely a function of big technology stocks.

Figure 3. Prior to the technology earnings bonanza on the last day of July, every sector was outperforming the technology sector except the perennially paltry energy sector.

Source: FactSet

Figure 4. Value sectors were also outperforming an equal-weighted basket of the FANMAG stocks.

Source: FactSet

Implications of a Dropping Dollar Ripple Across Markets

The sector performance we saw in July is not a fluke; take a look at one other large market dynamic: the recent slide in the value of the U.S. dollar. After peaking coincident with the height of the coronavirus fear as measured by the VIX (CBOE Volatility Index) at the trough of the equity markets on March 23, the U.S. dollar has dropped precipitously. It has plummeted 9.1% over the last four months, with the downward slide accelerating sharply for a 4.0% drop in July. Materials and industrials are two of the sectors most negatively correlated with the U.S. dollar. As a result, if the dollar continues its drop, we could see further outperformance in these sectors relative to sectors such as technology and communication services.

The ripples from the U.S. dollar did not stop with domestic sector performance. Other asset classes that are negatively correlated with the U.S. dollar also displayed strength in July, notably commodities and international equities. Regarding the former, 22 of the 23 commodities in the Bloomberg Commodity Index were positive during the month (Figure 5), which is the largest number since December 2010, when all 23 were positive.

Figure 5. Commodities are moving higher in lockstep with the weakness in the U.S. dollar.

Source: FactSet

As for international equities, the performance of both the EAFE Index and Emerging Markets (EM) relative to domestic equities has improved recently. Of the two, we believe EM has been stronger; even though a weakening dollar impacts both indices, it tends to impact EM more due to alleviation of dollar-based debt burdens, which are more prominent in EM countries. Our model is becoming increasingly constructive on EM, and we may look to take a position there in the near future.

Structurally, we feel there are reasons to remain bearish on the U.S. dollar, but nothing goes straight down without a relief bounce as short sellers cover their positions. We believe the U.S. dollar is sharply oversold and is likely poised for a bounce. Therefore, the strong performance we have seen in international assets, commodities, and domestic sectors with the highest negative correlation to the U.S. dollar could be set up to take a breather. In the bigger picture, though, the greater domestic breadth and improved performance in international assets should be positioned to continue with some fits and starts, and this strength should allow the market to stay on solid footing while technology stocks consolidate and work off overbought conditions.

Large Cap Growth continues its outperformance over Large Cap Value. July was very much a reversal from June: whereas Value came on strong at the beginning of June and Growth came on strong at the end; Growth continued strong through July, while Value was a bit weaker but then posted a strong rebound in the back half of the month. However, unlike June, Value’s improvement against Growth during July was not a result of Growth declining so much as the Value sectors improving. Again, we attribute much of this gap-narrowing to the dollar weakness that accelerated in the middle of the month, given the aforementioned improvement in sector performance and market breadth. And, just as in June, it bears repeating that the strong Growth performance in July is not due only to FANMAG; during July, the equal-weighted NASDAQ-100 index performed in line with the market-cap weighted NASDAQ index. In other words, the size of the FANMAG stocks did not have a disproportionate effect on the index during July, except for the last day of the month.

Gold and Silver Have Their Strongest Months in Years

The precious metals continue to perform well even as equities rise, with their best performance in over nine years. Gold broke through $1,900 a mere 17 trading days after breaking above $1,800, reaching a new all-time high and now sitting just below the psychologically important $2,000 level. Silver’s price action was even more powerful, smashing through the $21 resistance to reach levels not seen in over seven years. Our model remains very constructive on gold; we remain optimistic on gold both technically and fundamentally. Figure 6 presents a follow-up to last month’s chart of gold, showing the breakout that was brewing in June.

Figure 6. Last month’s chart was showing a gold breakout brewing in June…

Source: FactSet

Figure 6 (cont.) …and the breakout came to fruition, but it is somewhat tactically stretched and needs to consolidate.

Source: FactSet

Some are calling precious metals a bubble, but we respectfully disagree. Although gold has broken to a new all-time high in nominal terms, it remains below an inflation-adjusted all-time high; the disparity in silver is even greater, with silver not even close to its nominal or real all-time high (Figure 7). That said, structural optimism does not preclude these assets from getting ahead of themselves and needing time to settle down before resuming the next leg higher. As both are sharply overbought, they will likely need to consolidate and/or pull back before resuming bullish trends.

Figure 7. Although gold has broken to a nominal all-time high, we note that: 1) silver remains at less than half of its all-time nominal high, and…

Source: FactSet

Source: FactSet

Figure 7 (cont.) …2) both Gold and Silver remain below their all-time highs in real terms.

Source: FactSet

Source: FactSet

The Outlook Appears Positive, if Somewhat Precarious

Fixed Income returns remain relatively consistent as interest rates have stabilized and credit spreads have continued to contract. The Barclays U.S. Aggregate Index posted gains of 1.3%, which is the fourth-straight positive month (+1.78%, +0.47%, +0.63%, +1.3% in the months from April through July, respectively). While not robust by any means, we believe these returns will remain relatively stable and consistent so long as the economy remains weak (i.e., interest rates will remain low) but does not weaken further (i.e., credit spreads will remain contained). Any substantial improvement in the economy may hurt Fixed Income returns, as interest rates rise. In such a scenario, we believe modest deterioration in Fixed Income returns would be more than made up by stronger equity returns, both in magnitude (i.e., the gains in equities would be of larger absolute value than the losses in Fixed Income) and in quantity (i.e., because we are overweight Market Risk).

Reiterating what we said last month, while the market remains in a strong position now, we believe there are two important areas that are key to the rally’s continued viability: bond yields and corporate credit spreads. While credit spreads have improved consistently since peaking in late March, we would be remiss if we did not mention that low bond yields are a concern. Although lower bond yields, in and of themselves, make stocks more attractive, yields that are too low relative to yields of recent months are a harbinger of continued economic weakness; this will likely have an impact on stocks at some point. Our team remains vigilant and has multiple models in place to help detect. Still, we would feel more optimism if we could see bond yields rise a bit to indicate economic weakness may be abating.