Morgan Stanley

The market has started to favor stocks that could perform well in an economic recovery, but it is early days for reopening and there could be setbacks.

A quote attributed to Vladimir Lenin seems particularly apt for describing current markets: “There are decades where nothing seems to happen and then there are weeks where decades happen.”

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A bear market cycle ordinarily takes 18 to 36 months to play out, but this one has been compressed into just 10 weeks. We’ve gone from a record high in the S&P 500 in mid-February to a 34% plunge by mid-March, to now retracing more than half of that loss. Already, stocks are starting to rotate to small caps, value stocks and cyclicals—areas that normally do best in an economic recovery.

Since the sectors and styles the GIC most strongly favors  are suddenly outperforming the tried and true winners of the last 11 years, you might think we would embrace this move. But it is early yet for investors to count on such trends continuing. Let’s take a closer look at the recent reasons for optimism and why perhaps that should be tempered:

  • Many states are starting to slowly reopen. With signs the COVID-19 infection curve is flattening and progress on testing and treatments, many states are starting to gradually reopen for business. This is happening roughly a month earlier than expected. Yet it’s unclear whether this will have a negative impact on the trajectory of the pandemic or if consumer spending will rebound.
  • Some recent economic numbers have been improving. A few economic reports have started to come in better than expected. Weekly jobless claims have been decelerating each week and April readings on manufacturing came in better than forecast. However, first quarter GDP and consumer confidence were terrible. A case can be made that those readings represent a kind of capitulation that comes before an economic repair phase, but I think we need to see more evidence.
  • Earnings disappointments have been digested without a major market setback. Earnings season wasn’t pretty, but markets have absorbed the bad news. Credit markets have largely re-opened, commercial bank lending skyrocketed and the Fed continues to provide ever more support for the hardest hit areas of the economy. But for the market rotation to be sustained we don’t just need an end to deteriorating data but a hint at improvement.  

As hopeful as we are that the worst of the crisis is behind us, we have to admit that the market rotation into reflationary sectors may be early right now. As some of the hardest hit names bounce back, investors buying back borrowed securities to close out positions, known as short-covering, may be playing a role.

My advice is for investors to remain patient until we see clearer signs that a prolonged move is underway. While markets are strongly anticipatory, they may not be as completely disconnected from economic fundamentals as the headlines would suggest.

This article is based on Lisa Shalett’s GIC Weekly report from May 4, “Reopening Rotation?” Ask your financial advisor for a copy or find one here