As market claws back, near-term worry list grows

It seems clear to us that the longer-term setup for the market looks bullish: by late winter, all the uncertainties still facing us—a Covid second wave, the vaccine development, the election outcome and the recovery’s trajectory—will be behind us. The economy and earnings will be in a strong year-over-year comeback mode, a big fiscal stimulus package will be forthcoming almost whoever wins the election and the Fed has told us it will be standing down.

These factors are behind our 3,800-4,000 target on the S&P 500 for 2021 and our recent decision to, for the first time in years, tilt our equity overweights toward international and towards value stocks, which should be the biggest beneficiaries of what we expect will be a sustained economic recovery. But short-term, we are “cautious bulls,’’ holding to a relatively modest 20% equity overweight in our stock-bond models on concerns election results could drag into December and possibly end up in the U.S. Supreme Court, the second Covid wave could prove worse than we expect and a new stimulus bill could stall.

We got a taste of this in the market this morning as banks got us off to a nice start to an earnings season that likely will be good, but with conservative guidance. As indicated by bellwether J.P Morgan, which had solid results, no management team has an incentive to speculate on the recovery given the uncertainties listed above. And as we are seeing with today’s price action, forward guidance is probably more important to investors at this stage than trailing Q3 numbers and beats against low expectations. Let’s take a look at the top three worries:

1. The Covid news might be worse before it gets better. Clearly, infection rates are rising in the West, though hospitalizations and deaths, which we think are more important to understanding the severity of the so-called second wave, have remained muted. Our guess is that a combination of improved though not perfect social-distancing implementation, better treatment protocols, drugs and understanding of the disease by the medical community, and the coming vaccine are all combining to make Covid into something  we can live with and work through, albeit at 75% speed. But we are entering the winter flu season, and the Covid overlay will just make things worse and add to near-term uncertainty.
2. The economic recovery news is likely to stabilize and enter a period of slower improvement. In some ways, the “easy lifting” of the economic restart already has happened as industries less impacted by social distancing, such as housing, rails and autos, have joined the lockdown beneficiaries in tech, e-commerce and health care to feed a “V” recovery off the March/April depths. Now, the economy needs the more-devastated, still half-operational service industries (traditional retailing, tourism, travel, restaurants, among others) to kick in. This will be a longer grind. Many players will not come back at all. So the economic gains from here will be harder won.
3. The election news and aftermath might create volatility. Our guess is that President Trump’s numbers have troughed, now that the debate aftermath and his Covid experience are behind him. While he may yet lose the election, he could make it close enough in the swing states to result in a long period of recounts and litigation before the outcome is finalized one way or the other. Even if this doesn’t happen, the market of late has been enjoying early the traditional post-election honeymoon around the victor, in this case perceived as Biden leading a blue wave, so the upside on that outcome if it happens might already be behind us. And when markets begin to assess some of the less growth-friendly aspects of a blue wave, most notably higher taxes and regulation, the hangover might hurt. Either way, we don’t see politics as being a positive from here through year-end.

For now, the markets have been willing to look through these near-term uncertainties to what is likely to be a pretty good backdrop for next year. But we’ve got to get there first, and we wouldn’t be surprised to see a 5-10% pullback in the interim. If it comes, we probably would recommend using it to get more aggressive in stocks given our optimistic longer-term view.