After a powerful rally of more than 47% over 11 weeks (from the equity market’s March 23 intraday nadir through this past Monday’s cycle high), the S&P 500 suffered a sharp correction of more than 7% over the past three days. Stocks were frothily overbought, in our mind, in the wake of the equity market’s sharpest 50-day rally in history. This week’s welcomed correction is precisely in line with the healthy, cleansing pullback of 7-10% that we have discussed previously. Technically speaking, the S&P came right down to successfully test the important 200-day moving average at 3,014. Although stocks have rebounded this morning, we can’t rule out a further retest of the 50-day moving average at roughly 2,900, which would imply a 10% correction from the top. But we do not envision a more draconian retest of the March 23 bottom at 2,190, which we continue to believe will mark the bottom of the S&P coronavirus collapse.
What sparked the correction? In our view, there are four fundamental issues that have been percolating recently, which collectively have caught the attention of investors this week.
No. 1: Is the dreaded second wave here? New data suggests several key states, including Florida, Texas, Arizona and southern California, have seen a spike in coronavirus infections in recent weeks, despite their more sultry temperatures and a national trend in which infections and mortalities continue to grind lower. What’s causing this, and without vaccines in place, does this augur for a second wave of infections nationally?
- Did we reopen the economy too quickly in those states, or perhaps prematurely drop the need for protection, such as using face masks and maintaining social distancing?
- The FDA has already approved 74 different fast-track coronavirus tests to date, and President Trump invoked the Defense Production Act to produce enough cotton swabs and chemical reagents to execute about 50 million tests per month nationally. So is the spike in infection rates simply a function of wider and more aggressive testing, such that we now know that many previously asymptomatic persons, in fact, have Covid-19?
- Have the violent protests and looting in major cities in the wake of George Floyd’s senseless murder in Minneapolis on Memorial Day inadvertently spread the virus?
- The Wall Street Journal reports that the heaviest concentration of infections in these states appears to be centered in nursing homes, prisons, meat-packing plants and Native American reservations. Absent those hot spots, are the remaining state trends comparable to national levels?
- Regardless, we appear to be making rapid progress on the vaccine-development front, with a half-dozen drug companies planning to enter Phase III human clinical trials next month. Some doctors suggest that we may have vaccines available for emergency use as early as this fall. Consequently, it’s unlikely that we would shut down the U.S. economy for a second time this year.
No. 2: Fed scares investors? At the conclusion the Federal Reserve’s remote 2-day policy meeting on Wednesday, Chair Jay Powell said during his press conference that in response to the pandemic, the Fed will keep the upper band of the fed funds rate at 25 basis points through year-end 2022, which is a year later than we have been modeling. He also expects the Fed to accelerate its bond-buying program to record levels, to keep interest rates low and continue to orchestrate the Fed’s planned wealth effect, which should keep stock prices rising. Further, the Fed’s summary of economic projections expects the official unemployment rate (U-3) to fall to 9.3% this year and to 5.5% in 2022, with GDP estimates of 5% in 2021 and 3.5% in 2022. It’s all good, in our view, so we’re unclear as to why the market would view the Fed’s extraordinary monetary policy support amid the uncertainty of the coronavirus to be a bad thing.
No. 3: Trump’s re-election odds falling? After bungling an empathetic response to George Floyd’s tragic murder and the subsequent wave of protests nationally, President Trump’s poll numbers have plunged. The latest Gallup survey had his approval rating plummeting from a personal high of 49% to 39%, with even Republicans and Independents abandoning him. According to RealClearPolitics, Trump’s average approval rating of all surveys is now down to 42.3%, his lowest level since last November.
So the odds of Vice President Joe Biden winning the contentious presidential election in November have risen, along with a potential Democratic sweep, as control of the Senate has presidential coattails, in our view. How might consolidated Democratic control of Washington in November impact fiscal policy? According to our research friends at Strategas Research, we can expect sharply higher corporate and personal tax rates, the elimination of the income cap on Social Security taxes, and sharply higher taxes on capital gains and dividends, among other changes. At a minimum, this regime change could result in slower economic and corporate profit growth and lower stock prices. Consequently, stocks may have fallen this week to begin to discount the possibility of a Democratic sweep in November.
No. 4: Is Armageddon coming? First-quarter GDP was down by 5% (quarter-on-quarter, annualized), while corporate earnings fell 13% year-over year (y/y), with the U.S. economy closed for only the last two weeks in March. But with the economy voluntarily shut down for much of the first two months of the second quarter, the upcoming readings next month on GDP and corporate profits will be one for the ages, and not in a good way. We here at Federated Hermes are estimating second-quarter GDP to contract 27.8%; the consensus is at -35% and the Atlanta Fed’s GDPNow model had been at -53.8% before improving to -48.5% this week. Second-quarter corporate earnings could plunge by 42% y/y, according to Credit Suisse. So investors may have been locking in some outsized, near-term profits this week ahead of some very difficult GDP and corporate earnings reports next month.
Buy the dips
According to our research friends at LPL, following the other largest 50-day rallies in history, stocks were higher 100% of the time 12 months later, with average returns of 17.3%. That remains consistent with our economic and financial-market forecast here at Federated Hermes, as we are forecasting a sharp second-half rebound in 2020, which we believe will continue into 2021. We expect this deep recession to be contained to the first half of 2020.