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Windsor Perspectives: Q3 2020

Windsor Perspectives: Q3 2020

| October 15, 2020

Windsor Perspectives: Q3 2020

Party Like It's 1999?

The stock market continued to advance during the third quarter as a whole, despite turning downward in the quarter’s final weeks.

The broad U.S. stock market, represented by the S&P 500 index, reached a new all-time high in September before surrendering some of those gains. Its strong showing was driven by a handful of the largest stocks in the index—particularly Apple, Microsoft, Amazon, Facebook and Alphabet (formerly Google).

In fact, the percentage of the S&P 500 Index represented by its top 5 and the top 20 constituent firms has reached a historical high—higher, even, than the late 1990s prior to the technology bubble bursting (see chart below). During periods of time when a relatively narrow slice of the market—in this case, its largest companies—propels market advances, there is reason for concern. After all, even the largest, healthiest trees don’t grow to the sky forever.

The top 5 and top 20 firms make up a historical amount of the market cap of the S&P 500

Source: Bloomberg, September 4, 2020

Besides sheer size, the other main driver of positive stock market returns has been the technology sector. The Nasdaq 100, which is heavily influenced by technology holdings, is still at an all-time high despite the September downturn. It advanced 11.1% for the quarter and has grown 30.7% year to date.

Though the tech-sector and top-5 and top-20 performance is somewhat reminiscent of the tech bubble, other market factors are not. In particular, a number of market sectors have lagged and have yet to recover to their previous highs. Investors can take some comfort that small-cap and cyclical stocks still trade at more reasonable or even depressed levels. This may mean the market is not quite as “hot” as it looks at first glance.

The same reasoning applies to value-oriented stocks—such as many companies in the financial, energy and industrial sectors—which have also dramatically underperformed this year. As interest rates declined toward zero, growth stocks have dramatically outperformed value stocks. This is because investors are placing a higher premium on long-term growth potential versus the attractiveness of price-to-earnings for value stocks.

Another area of underperformance—and, again, a source of some comfort that the market may not be quite as overheated as apparent on the surface— is stocks in international companies. Both developed and emerging markets stocks have failed to recover to their pre-COVID highs and are attractively valued.

In short, we are seeing a sharp divide between the primarily tech-driven, large-cap high flyers and most everything else. Ironically, the thing to celebrate most may be that while those other sectors dragged down performance in the recent quarter, their relative valuation advantage may represent opportunity for future growth.

Interest Rates: Even Lower

Interest rates remained low with short term interest rates, represented by the one-month Libor, finishing at a yield of just 0.15%. Long term rates, represented by the 10-year U.S. Treasury bond, finished the quarter at a once-unthinkably low 0.72%.

Low interest rates are heavily influenced by Federal Reserve Bank bond purchases. The Fed now owns over $7 trillion of bonds—an increase of more than 75% this year.

While low interest rates can be helpful in the recovery of a struggling economy, they can negatively impact the cushion that the bond portion of a portfolio can provide during a market decline. Even with lower interest yields, bonds still play a vital role in the portfolio but are unlikely to provide the same type of cushion experienced over the last decade.

Here is a brief look at the fixed-income market and related portfolio implications:

  • For bonds with strong credit quality,  investors typically seek to purchase bonds in periods of economic and market stress, driving the price of the bond up which consequently reduces the interest yield.
    • At the current low levels of interest rates, bond prices don’t have a lot of room for growth before yields reach 0%. And while the Federal Reserve has been consistent in its commitment to avoid negative yields on bonds, as is the case several other countries such as Germany, the market could test that in the future.
  • In response to low yields, many investors have purchased bonds of companies with lower credit quality since they offer a higher yield to attract investors for taking on additional risk.
    • These lower-quality, higher-yield bonds are more sensitive to the economy and tend to fall in value when the stock market falls. This is because investors become concerned issuers will default on their bond payment obligations.

The Federal Reserve has provided support to bond issuers who have run into financial difficulty during the pandemic and that has emboldened investors to take more risk thinking the Fed “has their back.”

Time will tell if that strategy is successful but given an unfavorable history for that type of investing logic, we are keeping our bond portfolios oriented toward the higher quality issuers to provide ballast in client portfolios.

In the Rearview Mirror: The Shortest Bear Market in History

While the stock market decline in response to the COVID epidemic was one of the fastest in history, it was also one of the shortest as well. Although the cause of this bear market was unlike anything experienced in the U.S. prior, historical perspective on the nature and duration of bear markets is helpful to understand.

For example, the chart below shows every bear market since the crash of 1929. Notice the average timeframe for a falling stock market is 22 months until stocks hit bottom and then begin their recovery.

Recessions and unexpected events are inevitable but notoriously difficult to forecast. That’s why it’s essential to keep perspective based on an appropriate investment time horizon.

In our financial planning work, we are ever mindful of our clients’ risk comfort zone and build portfolios where clients can maintain confidence in turbulent times, which often provide some of the greatest opportunities when viewed over the long haul.

Historical Duration of a Bear Market

Source: J.P Morgan Asset Management

Glancing Ahead

While the economy has improved since its worst levels during broad-based lockdowns, considerable progress is still needed across many economic indicators before an economic recovery reaches pre-pandemic levels.

We are monitoring improvements in both cyclical economic factors—such as consumer spending and corporate earnings growth—as well as potential non-cyclical, lasting changes to the employment picture and consumers preferences. Specifically examining the lasting impact of technology to replace certain types of employment as well as long-term changes in purchasing behavior in hospitality, travel, commercial real estate and education.

The markets will continue to face short-term uncertainties, particularly with the elections ahead in November. As we discussed in our September WindsorBrief, it’s ultimately policy, not politics, that has an impact on the economy. However, economic policy is only one factor in a complex, global economy. Rather than speculating on unknowable outcomes such as election results, we will be prepared to analyze actionable policies from a financial planning or investment perspective.

Looking ahead, the likelihood for a COVID- 19 vaccine by Q1 2021 continues to grow. A medical treatment for the virus would accelerate the path to economic normalization, which could in turn lift the earnings and share prices of the underperforming cyclical and value stocks we noted at the outset of this letter.

And with the aforementioned U.S. equity market concentration at a record level, a vaccine could be one potential catalyst for market rotation away from the mega cap growth stock leaders to a more broad-based market rally.

Finally, because investors have plenty of cash available (see chart below) to purchase equity investments as signs of economic recovery become more apparent, the future direction of markets will take its cue from the level of the economic recovery.

Money Market Assets

Source: ICI, Fundstrat

One risk we will maintain focus on is potential signs of inflation. Large government deficits and significant increases in the money supply could spark inflation, which has been low for most of the last decade. Should an uptick in inflation arrive, that could put pressure on both stocks and bonds.

Closing Thoughts

We continue our focus to interpret the changing financial landscape by analyzing the factors critical for long term investment success— changes in fundamentals, valuation levels and careful portfolio construction—while at the same time ignoring the noise that can take investors off track.

Our investment decisions are made in the context of our clients’ financial plans, which are unique in every case. We thank you for your continued trust in our firm and our process to work toward successfully achieving outcomes consistent with your long-term goals.

Thank you for allowing the Windsor Wealth Management Team to continue to earn your trust and confidence in the services offered to you. We appreciate your loyalty and always welcome feedback from you.

Dream boldly. Plan wisely.


Market Snapshot as of 9/30/2020


Rates, Currencies & Commodities


Source: Bloomberg