Market Insights

In recent conversations with clients, we are getting fewer questions about our economic outlook. Many of our clients are themselves business owners and have already felt the pandemic’s economic pinch firsthand. They don’t need investors to explain the fear gripping Main Street. What puzzles them is how the stock market could be so at odds with the economic gloom.

While entire industries are on the sideline during the pandemic and the unemployment rate continues to climb, stocks have recovered much (though not all) of March’s losses. So, what’s behind the rally that seems so out of sync? In short, we think the market is confident about the safety net the Fed and the government has provided. Given the size and scope of that safety net, markets are already looking ahead to when the quarantine ends.

The S&P 500 bears an extreme risk: too few stocks account for too much of its weight. The index is experiencing extreme concentration risk not seen in the last 30 years, with its five largest stocks now accounting for more than 20% of the entire index.

The chart below shows just how out of balance the weightings of the largest S&P 500 stocks have become. Currently, the total index weight of the five largest holdings is more than five standard deviations¹ above normal.

Innovation within the biotechnology, medtech and diagnostics industries makes the health care sector an exciting area to invest. Valuations also make it precarious.

At Dana funds, we have balanced the risk and opportunity within the sector with a steadfast focus on valuation discipline. We are investing in innovation within the sector – but at what we believe is a reasonable price. We also find opportunity with companies that have simpler stories, but nevertheless benefit from long-term, secular tailwinds affecting health care.

Stocks within both camps have been large contributors to performance over the past year, and are a primary reason stock selection within the health care sector has contributed to relative performance for our Epiphany Fund.

While ESG interest is undoubtedly on the rise, the category hasn’t reached its full growth potential. One issue potentially holding it back? Clarity.

An October 2019 report from the Institute of International Finance¹ found that financial firms are using nearly 80 different terms to describe various forms of sustainable investing. As the report describes, this is creating confusion for would-be investors:

“At best, this confusion makes it hard to compare investment products and for clients to understand the differences in offerings,” the report states. “At worst, it facilitates greenwashing—intentionally misleading investors or giving them a false impression about how well their investments are aligned with their sustainability goals.”

With fund inflows nearly quadrupling to a record $20.6 billion in 2019¹, ESG interest has clearly reached a tipping point … but the COVID-19 pandemic could be a catalyzing event that triggers even broader awareness this year.

As corporations grab positive and negative headlines for their response to the outbreak, we expect more consumers to take interest in companies’ treatment of their employees, customers and community, and invest accordingly.

The trend is already playing out in the first quarter, with ESG funds experiencing a record $10.5 billion in inflows … even as stocks crossed into bear market territory.²

The arguments in favor and against active management are too long to tackle in a single blog post – and we won’t try to do so here. But as stocks find their footing after March’s downturn, we believe there are a couple important factors poised to work in active managers’ favor: size and quality. Both elements could be significant tailwinds for active managers in the months ahead, particularly when considering the composition and performance of indices heading into the slide.

In Current Environment, Quality Matters

Investment philosophies and styles vary, but many active managers – including Dana – emphasize “high quality” companies in the stock selection process. This means a preference for companies with stronger balance sheets, durable earnings streams and lower debt levels. Conversely, it means avoiding companies with high debt, and relatively low return on equity (ROE)* or return on assets (ROA)**.

While 2020 has been rough for all stocks, the pain has been most acute among small caps. As of April 15, the Russell 2000 Index was down -28.73% this year, a little more than twice the drop of the Russell 1000. While losses have been painful, we would encourage investors to stay patient; there is a strong case for small caps to take a market leadership position in the months ahead.

That case starts with relative valuations. Small caps have historically had higher valuations than large caps, but the valuation differential between the two groups is in the 21^st percentile.¹ In plainer terms, that means the valuation disparity between small and large caps is this close less than a quarter of the time. Following these cheaper relative valuation extremes, small caps tend to recover.

It’s a natural reaction to every bear market. As stocks plummet, clients start wondering whether they should pull money out of equities and wait on the sidelines until conditions improve. If you’re an advisor, you may have had several conversations along these lines recently. We salute your efforts to help clients stay the course.

At Dana, we realize the importance of staying fully invested and reflect it in our investment process, which dictates that funds hold minimal cash. Our view is that it is always better to stay fully invested because not even experts can perfectly time a rebound.

However, we know it can be challenging for advisors to keep their clients invested through a downturn. In the spirit of helping, below are five quick-reference stats and charts we’ve collected that paint a picture of why we believe it’s important to stay in equities through the entire market cycle:

As 2019 ended, the backdrop for the energy sector looked relatively solid. Oil prices were up more than 30% in 2019, and future demand appeared firm, as cooling trade tensions between the U.S. and China led many to believe the economy would improve.

It would have been hard for nearly any expert to predict what would happen next. The coronavirus has severely affected the global economy and, in turn, sapped energy demand. At the same time, a price war between Russia and Saudi Arabia has also driven oil prices lower. As a result, the S&P 500 energy sector is down nearly 52% this year, trailing well behind the next biggest sector laggard – financials – which is down 31%.

On the other hand, heading into 2020 few would have predicted utilities would be the best performing sector, down 13% so far this year, but outperforming others due to its defensive nature.

The only thing more striking than the depth of the recent market rout is its speed. It took the S&P 500 just 22 days to fall 30%, the quickest drop of that magnitude in history. The fast freefall has left little time for equity strategies touting downside protection to deliver it … but give it a moment. Stock selection can help navigate equity market downturns, but it provides greater value over a longer period than three panic-stricken weeks.

At Dana, we pride ourselves on the ability to outperform in sustained bear markets and our strategies did so through both the tech bubble and great financial crisis. This is largely what we would expect, given our investment process. We focus on high-quality companies that trade at a discount to their peers. These companies tend to outperform when the economic outlook sours and the rest of the market gravitates toward companies with stable balance sheets and steady earnings growth.

We see early signs the market is once again starting to differentiate between high and low-quality companies. But a bias toward smaller companies and a tilt toward value hasn’t yet helped us in the current downturn.

As stocks slid from record highs to bear market territory in a matter of days, not months, the thing that would really make a strategy shine in the current market environment is to increase one’s allocation to cash. We view this as a market timing call, however, and it’s simply not what we do.

Is Your Manager a Timer or an Investor?

In the earliest stages of a bear market – particularly this one – the best way to cushion the fall is to hide in cash or short equities. Undoubtedly, there have been some long-only managers that have probably benefited from holding excessive cash positions during the recent rout.