Well, that was historic. The fastest 30% drawdown in the history of global equities in the first quarter was followed by the largest 50-day advance in market history in the second quarter. The S&P 500® was back above 3,100 on June 3 and the Nasdaq hit a record high on June 10. Meanwhile, commentators have been lining up to claim that markets are detached from fundamentals.
We’re not so certain that investors have it wrong. For sure, markets seem to be priced for an optimistic outcome of no meaningful second wave of infections as lockdowns are lifted. But record levels of fiscal stimulus, sustained low interest rates and ongoing low inflation create a supportive environment for risk-asset outperformance.
Our previous quarterly report in late March laid out a cautiously optimistic case for riskier assets, such as equities and credit, to outperform defensive assets like cash and bonds. This was based on our cycle, value and sentiment (CVS) investment decision-making process.
Value had improved following the market crash, the cycle outlook was turning positive with central banks and governments in “whatever it takes” mode and, most importantly, our composite contrarian indicator of market sentiment was providing one of its most extreme buy signals.
Oversold conditions imply that investors are cautious and worried about downside risks. These conditions provided a springboard for risk assets to rebound as the economic impact of the lockdowns turned out less bad than feared and as a possible second wave of infections failed to materialize by mid-June.
The market rebound means that value is no longer compelling for global equities or credit. On the other hand, the cycle outlook has improved as fiscal and monetary stimulus announcements continue and economies start to emerge from lockdown.
The bottom of a major recession when stimulus is flowing is one of the few times it is possible to have a relatively confident view on the cycle. Sentiment, unsurprisingly, is no longer as supportive. Our composite contrarian indicator, as of mid-June, is providing a neutral signal. This means that the support from oversold conditions is waning and markets are at greater risk of pulling back on negative news.
Neutral value, neutral sentiment and a supportive cycle give us a more balanced view on the investment outlook. Looking near-term, markets are vulnerable to negative news after a 40% rebound and with sentiment on the verge of triggering our overbought signal. Over the medium-term, the supportive cycle outlook should allow equities to outperform bonds.