Market Update

The S&P 500 rose 3.2% to 2955.45 last week. The index gapped up at the open on Monday. It broke above the 4/29 recovery high of 2954.86. The S&P 500 had failed to retake that level on May 12th. A multi-day selloff followed that bottomed at 2766.64 on May 14th. Friday the 15th saw a close of 2863.7. The low last Monday was 2913.86, leaving a 50-point gap between it and the prior day close. The rest of the week was a battle for 2955. The index traded on both sides throughout the week. The bulls won the battle with the close above the April 29th high. A slender victory but one that points the market higher in the short-term.

The market action continues to resemble bear market rally trading. Big gap up openings and large percentage intraday moves. Expect the 50-point gap to be filled at some point. A veteran trader who worked at Bear Stearns at the time told me the market hates gaps. He claimed they were always filled. It has been a few decades since he spoke those words, but they have tended to ring true. The bulls won the battle of 2955 last week, but the 100-day moving average is close at 2970. The 200-day moving average sits at 3,000. Tough going for the bulls. Another big gap up opening to flush out resting, buy stop-loss orders and suck in more quantitative investors relying on their algorithms? We will see. (I wrote this on Sunday morning. It looks as if a big gap up is exactly what is on the menu.)

Longer-term the most likely direction is down. Economic fundamentals continue to worsen, and earnings will eventually matter. The bear market rally could last a few more months, even into the fall. It could also end much sooner. We will have to see about that as well.

Economic Update

Housing starts in April were 891,000 down from 1.276 million. Building permits were 1.072 million down from 1.356 million. Housing is an important sector generating significant economic activity. Existing home sales fell to 4.33 million in April from 5.27 million the prior month. As the National Association of Homebuilders writes, “…job creation through housing is broad-based. Building new homes and apartments generates jobs in industries that produce lumber, concrete, lighting fixtures, heating equipment, and other products that go into a home. Other jobs are generated in transporting, storing, and selling these products. Additional jobs are generated for professionals such as architects, engineers, real estate agents, lawyers, and accountants who provide services to home builders, home buyers, and remodelers.”

Initial jobless claims were 2.44 million, worse than expected, but down from the 2.69 million the prior week. Total jobless claims were 38.6 million in the last nine weeks. There is no precedent. The Markit May manufacturing PMI was 39.8 and the Markit services PMI was 36.9. Both indices improved from April but are still well into contractionary territory.

The economic data is horrific. The hope is for a quick recovery as states reopen. The Congressional Budget Office (CBO) is not as optimistic. The CBO believes the U.S. economy’s recovery will drag on through the end of 2021, according to the Wall Street Journal. There is increased pessimism among economists about a quick recovery, according to a recent Reuters poll. True, a recovery is still forecast for the second half. Yet economists do not believe the economy will come close to regaining the ground lost in 2020.

Investors will likely lose money in bonds

Some of the most successful investors in the world are not buying stocks yet. Warren Buffet is selling, not buying. Stanley Druckenmiller says the risk-reward for equity is maybe as bad as he has seen it in his long career. GMO has recently moved from 58% equity to 25% equity in its institutional fund. Jeremy Grantham is the co-founder of GMO. He has made a successful career as an asset allocator. He wrote on March 10th, 2009, that stocks were undervalued and investors should buy. Of course, that was one day after the market bottomed, ending the 2007-2009 bear market. Grantham also wrote in 2002 that the S&P 500 would bottom at 670 in seven years. The bear market low hit in March 2009 was 666. GMO’s seven-year forecasts for various asset classes are worth paying attention to.

GMO’s current forecast has emerging market value stocks returning a real 11.8% over the next seven years. Emerging market and international stocks are next in predicted performance. The U.S. stock market will trail according to the GMO forecast. Large U.S. stocks are expected to lose money. The 60/40 stock/bond portfolio is a mainstay of asset allocation among institutions and individual investors. For almost 40 years that asset mix has worked well. Bonds served as a cushion when stocks struggled. Bonds worked well during those periods because interest rates would fall when stocks fell, pushing bond prices higher. Times have changed. Increasingly both stocks and bonds are falling at the same time.

Bonds will lose money over the next ten and twenty-year periods as interest rates move higher. Investors will need to find another hedge for their stock portfolios. GMO is forecasting a 3.8% annual loss for U.S. bonds over the next seven years. Only emerging market bonds are expected to have a positive return between now and 2027. Buffet, Druckenmiller, and GMO are not currently buying stocks. GMO doesn’t see much to like about bonds either. What is an investor to do?

Regards,

Christopher R Norwood, CFA

Chief Market Strategist