July 13, 2020
Princeton Global Second Quarter 2020 Investor Letter
After the significant decline in global equity markets during the first quarter, a strong rebound took place in the second quarter. For the U.S., the return of over 20% in the Standard & Poor’s 500 Index was the most robust quarterly performance since 1998. The markets responded favorably to aggressive actions of fiscal and monetary policymakers to stabilize markets and calm investor confidence. The gradual reopening of economies worldwide has also led to a partial rebound in economic activity.
The following table shows the performance of global equity markets over varying periods. The U.S. stock market has outperformed over all periods except for the 20-year duration, which was led by Emerging Markets. 10-year returns are healthy, while 20-year returns are below historical averages:
Following the surreal beginning to 2020, the investment climate has improved but remains highly uncertain. We continue to analyze the data of COVID-19 and the actions of policymakers; however, the future will be heavily influenced by variables that are beyond our knowledge and expertise. During this period of uncertainty, we believe a prudent approach is to focus on investments with an abundance of stability and quality with select areas of conviction.
“There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.” -John Kenneth Galbraith
The combined stimulus from fiscal and monetary policy mitigated the impact of the virus on the U.S. economy during the first half of the year. There is a strong probability that a new fiscal stimulus package will be enacted in the weeks ahead, which at the margin, should mitigate the negative impact of the pandemic. However, it is increasingly likely that a complete recovery in the U.S. economy will await the development and employment of a vaccine, with early 2021 being the most optimistic timetable.
Over the next several quarters, the key to equity market performance will be the pace of economic recovery
from the sharp global contraction during the first half of 2020. In the U.S., there is growing evidence that the spikes in coronavirus cases in states which were spared in earlier months will lead to a more uneven recovery. States such as Florida, Texas, and Arizona are pausing or even reversing aspects of the reopening of their economies in response to rising virus cases. The result will be a slowing in the rehiring process and increased caution among consumer spending, which accounts for 70% of the U.S. Gross Domestic Product.
The U.S. stock market will likely be characterized by above-average volatility in the coming quarters. There is a tug- of-war between the lack of attractive investment alternatives compared to stocks with the positive impact of stimulus on the one hand and the likelihood of an uneven economic recovery on the other hand.
As for other global economies and markets, the ability of countries to contain the virus will materially impact the investment outcome. Countries such as China, Japan, and Germany appear to have had the most success in containing the virus and dealing with the inevitable outbreaks. In particular, the Chinese stock market has performed well in recent weeks, providing a boost to emerging markets. In contrast, other countries such as the U.K., and those of Latin America have encountered difficulties. Consensus estimates for the global economy are a decline over 4% this year, followed by a partial recovery in 2021, again depending on the timetable for a vaccine.
Presidential elections and stock market returns
The upcoming election will also add volatility and uncertainty to the markets and influence the performance of investments in different industries. The “Presidential Cycle” shows a consistent pattern in which the first two years of a presidential term have tended to produce below-average returns while the last two years have been well above-average. Purely statistically speaking, the best scenario for the markets is a Democratic president and divided Congress. The lower return scenarios for the market are a Republican president and divided Congress and a Democratic sweep. (The first two years of a presidential cycle are dark blue, and the second two years are light blue):
Disconnect from Reality?
The stock market is rarely a simultaneous reflection of the economy; however, 2020 has been extreme due to the composition of the major indices. In 2020, the market weight S&P 500 index has outperformed the equal-weight S&P 500 by over 7.5%, meaning the average stock is performing considerably worse than the index. Several mega- cap companies have dominated the returns of market-weighted indexes, and these companies are in Technology industries that have been less impacted by the challenges of COVID-19. The challenging returns of small and mid-cap stocks more closely resemble the current state of the economy. Large-Cap Growth has been the only equity style to outperform in 2020, and the magnitude of outperformance has been remarkable:
Quality remains the overriding theme of our equity positioning and purchases. We define quality as companies with stable growth prospects, high profitability, low debt, and solid free cash flow conversion. During the second quarter, we continued our efforts to eliminate lower conviction holdings and replace them with companies that will emerge from the recession in a position of strength. Recent new additions have focused
on the Healthcare and Information Technology sectors, where we have considerable overweights vs. respective benchmarks. Our equity portfolios have significant exposure to the “Big Growers,” which have performed well during the pandemic. We have also maintained sector diversification and exposure in more cyclical industries, which enabled our strategies to fully participate in the market rebound despite the velocity of the rebound being more rapid than we anticipated.
We have maintained our list of stock ideas classified as “Now” and “Later” investments. “Now” are stocks we are comfortable owning through volatility and include several Tech, Health Care, and Defense companies. “Later” are stocks we believe will recover more after we see more evidence the economy can return to early 2020 levels. Due to the numerous factors of uncertainty, we continue to favor new investments in the “Now”
categorization. We also believe there will be sustainable changes to consumer and corporate behavior following the COVID-19 recession. We are focused on identifying industries and stocks that will benefit from these changes that are reasonably valued – examples are outdoor activities, familiar brands, and robotics.
In our Dividend Growth Strategy, we have increased conviction the depressed global interest rate environment should increase the appeal of stocks that can provide capital appreciation while still providing distributions above cash rates. The current dividend yield of our Dividend Growth portfolio is 2.7%, which is ten times the current 5- year Treasury yield of 0.3%. Income focused strategies have trailed the broader indices due to the recent outperformance of faster-growing non-dividend paying stocks; however, our approach has performed well vs. peers due to our balance of Growth and Value stocks. We continue to emphasize resilient free cash flow and dividend safety for our holdings, and avoid high dividend-yielding companies with high payout ratios, as we anticipate more companies to cut their dividends over the next few quarters.
In our managed Exchange Traded Fund portfolios, our global diversified equity exposure remains tilted
towards Value, Quality, and Mid-Cap fund styles. Consistent with our overall view, we have increased exposure to funds overweighted in quality factors, and consistent with our Dividend Growth conviction, we prefer Equity Income funds for Value exposure. Within fixed income, we continue to see value in investment-
grade Preferred Stock funds for higher-yielding exposure to complement our short-duration investment-grade holdings. Tracking error, liquidity, and low expense ratios remain key considerations in fund selection.
Fixed Income Strategy
Following the historic decline in U.S. interest rates during the first quarter, the pegging of short-term rates at zero by the Federal Reserve put further downward pressure on the two- and five-year Treasury obligations. The yield on the two-year Treasury note declined from 0.25% to 0.16% during the second quarter, while the five-year note exhibited a yield decline from 0.38% to 0.29%. On the other hand, the financing of much of the massive stimulus program in the longer end of the fixed income market resulted in thirty-year bond yields rising from 1.32% to 1.41% during the second quarter, while the yield on the ten year Treasury note was little changed at 0.66% vs. 0.67%.
Given the long period likely to be required for the Federal Reserve to achieve its policy goals of full employment and an inflation target of 2%, U.S. interest rates are expected to remain at current levels for the foreseeable future. Ultimately, the unprecedented levels of monetary and fiscal stimulus will have inflationary implications, but that development appears to be a long way off. Also, the spreads of “riskier” bonds have narrowed dramatically from March levels. On this basis, we believe that maintaining shorter than average durations and high investment-grade characteristics in our fixed income portfolios remain prudent.
Princeton Global Asset Management, LLC
This report is for informational purposes only and contains data based on information Princeton Global Asset Management (PGAM) believed to be accurate. However, PGAM cannot assure the accuracy of the data.
Past performance is not a guarantee of future results. Portfolio holdings and characteristics are subject to change. The information in this report should not be considered a recommendation to purchase or sell any particular security.
It should not be assumed that any of these securities transactions or holdings that may be cited were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of securities cited.