- Momentum stocks dominated performance, with little regard for valuation. This is surprising but explainable due to work-from-home (WFH) scenarios which have accelerated digital transformation and the secular shift to the cloud.
- Many economic and health uncertainties remain, preventing companies from having much visibility in terms of demand and earnings and we expect profit weakness through at least the third quarter across most sectors of the economy.
- We have added cyclicality to the portfolio and consolidated some positions to be more leveraged to a recovery in revenue and earnings once conditions normalize.
Equities staged a powerful rebound in the second quarter, paring most of the losses from the March, COVID-19-induced selloff with the support of significant economic stimulus, optimism over virus containment and better than expected earnings from information technology (IT) and Internet companies. The S&P 500 Index delivered its best 50-trading day performance in history from bear market lows in late March (+39.6%) and finished up 20.5% for the quarter, its strongest showing in 22 years. Volatility increased significantly as two powerful forces collided: the largest economic drawdown since the Great Depression against the largest fiscal and monetary support programs ever created.
Momentum stocks, which command a large weighting in the benchmark Russell 1000 Growth Index, maintained market leadership through the selloff and recovery. The benchmark gained 27.8% in the second quarter and is up 9.8% for the year, outperforming the Russell 1000 Value Index by over 1,350 and 2,600 basis points, respectively. These are the widest margins of growth dominance since the bursting of the dot.com bubble in early 2000.
Energy (+40.7%), which has a minimal weighting in the benchmark, and consumer discretionary (+38.3%) were the best-performing sectors for the quarter, boosted by a rebound in oil prices and the initial reopening of the economy, while IT (+33.6%) also outperformed.
The move straight up in the market, off the late March low, was astounding, especially coming during the midst of a recession with double-digit unemployment. The level of stimulus from the Federal Reserve along with the $2.2 trillion fiscal package passed to support individuals, small businesses and COVID-19-impacted industries, provided the liquidity and fixed the financial “plumbing” that was a major catalyst for the equity rebound. Typically, defensive sectors like health care and consumer staples hold up best in bear markets while cyclicals like industrials and financials lead recoveries. Defensives and cyclicals both lagged in the second quarter with consumer staples (+10.0%), real estate (+14.8%) and industrials (+17.9%) the weakest performers. As atypical as the equity leadership was in both the drawdown and the recovery, the complete shutdown of global commerce was equally unusual.
"Recessions have consequences and it is still very early days in truly understanding one of the largest economic drawdowns we have ever witnessed."
We manage a risk-aware diversified growth portfolio to generate consistent results throughout a market cycle. In the current cycle, IT and more specifically momentum stocks have dominated, with little regard for valuation. This is surprising but explainable as technology has been less cyclical due to the nature of the virus shutdown and work-from-home (WFH) scenarios which have accelerated digital transformation and the secular shift to the cloud. IT has not acted cyclical since the Global Financial Crisis as first software and now cloud are transforming the way enterprises operate.
First-quarter earnings were strong within IT, and outlooks across the board led with information security, cloud and data-related names among the best performers. Splunk and VMware were among the leading portfolio contributors during the quarter as enterprises focused on optimizing the WFH experience. Another difference in today’s near-zero interest rate environment has been the willingness of the market to discount good news further out into the future. Investors have been bidding up Apple and Nvidia, for example, based on product cycles 18 months away. Mid cap software names have massively rerated higher given the scarcity of perceived growth. We would caution that first-quarter earnings are meaningless now as we drift further into the year with enterprise budgets due to be cut across the board as companies reassess their revenue assumptions in what still is a very uncertain environment.
Maintaining diversification in a dominant period for momentum, with very narrow leadership, has caused the Large Cap Growth Strategy to underperform the benchmark in the second quarter and has contributed to our relative underperformance over the last 12 months. We continue to remain underweight IT versus the benchmark — the underweight was approximately 600 basis points as of June 30 — which became more tech heavy in the latest Russell index reconstitution.
Microsoft and four of the FAANG stocks (Facebook, Apple, Amazon.com and Google/Alphabet) remain the five largest stocks in the index and thus the five largest holdings in passive vehicles tracking it. Amazon, Microsoft and Apple have outperformed the market meaningfully year to date and over the trailing one-year period, boosting passive performance. We continue to maintain an overweight in Amazon, the best performer in the group year to date, as the company takes more share as a leader in consumer and enterprise trends that have accelerated amid the COVID-19 pandemic: e-commerce and hybrid cloud adoption. During the second quarter we added to Facebook, which saw increased engagement during the lockdown and as a leading video advertising platform should benefit as more activity takes place online.
Yet history has proven that market leadership by a narrow segment of companies is finite and at least one of the FAANGs — Alphabet — is showing signs of slowing growth due to its size. The stock has lagged the benchmark in 2020 and we reduced our position in June. The Alphabet trim as well as the sale of three other companies — Pioneer Natural Resources, Honeywell International and Charles Schwab — increases the portfolio’s active share, concentrating our exposures to ensure positive stock selection has a greater impact on returns.
A focus on valuation has also been a headwind this year as the priciest stocks in the Russell 1000 Growth Index have been performance leaders (Exhibit 1). Several software-as-a-service (SaaS) names that entered the index in late June have gained more than 40% year-to-date. Our price discipline and desire for consistent profitability, however, causes us to avoid most of these stocks as they trade at revenue multiples we view as unsustainable. One advantage we do maintain is a long-term perspective, which allows for patience in waiting for an attractive entry point into high-quality growth companies. This was the case in 2019 with salesforce.com, a SaaS leader we had been following for years before near-term volatility brought it into our buy range.
Exhibit 1: The Most Expensive Stocks Have Performed the Best
In addition to adding to names purchased opportunistically during the first-quarter selloff, we established a new position in Ulta Beauty, a cosmetics and skin care retailer. Ulta is a play on a cyclical recovery in consumer spending with a strong balance sheet that positions it well in the recovery to accelerate share gains versus competitors with its proven omnichannel approach, particularly the challenged department stores. Longer term, we see the potential for sustained mid-single-digit same-store sales and low-double-digit earnings growth.
Ulta, like aerospace and defense manufacturer Raytheon Technologies, energy drink maker Monster Beverage and auto part supplier Aptiv, is part of our ongoing effort to upgrade the portfolio with companies poised to deliver above-average growth on the other side of an economic recovery.
In the same way, we have trimmed or sold positions where we see near- to medium-term challenges. We eliminated the portfolio’s energy exposure with the sale of Pioneer. The vertically integrated shale producer is an excellently managed company, with prolific and visible long-term oil/gas production from its operations in the Permian Basin. However, the company is facing too many external forces, including a short-lived oil price war and continued deflationary production from OPEC+ along with a record decline in global energy demand, to give us the fundamental tools for proper analysis going forward. We exited Honeywell to manage portfolio exposure to industrials during a period of macro headwinds to capex. The company’s energy business in particular will likely be slow to recover due to a lack of visibility on global demand.
Discount broker Charles Schwab was also sold due to a policy environment likely to cap interest rate increases in the near to medium term. Broker-dealers’ revenue mix has shifted more to spread income in recent years from client commissions and asset management fees. Schwab led the industry in cutting trading commissions to zero for certain asset classes (U.S. equities, ETFs and options), which led to even greater reliance on spread income, as well as announced a merger agreement with TD Ameritrade.
Volatility has remained high through the equity rebound as a number of uncertainties still exist: the trajectory of the virus as a second wave of infections hits some states that have reopened their economies; the willingness of consumers to go out and spend again; the comeback in employment after massive layoffs; and the size of a potential new fiscal stimulus package. These questions prevent companies from having much visibility in terms of demand and earnings and we expect profit weakness through at least the third quarter across most sectors of the economy.
The market is factoring in a V-shaped recovery with S&P 500 earnings expected to recover in 2021 to a slight increase over 2019. Clearly that is the case for some companies like UnitedHealth Group and Nvidia, which have a good chance of growing earnings. Companies in areas like aerospace, autos and travel will have a much tougher time. In fact, the median return for stocks in the benchmark is -1.8% year to date compared to +9.8% for the overall index, with 54% suffering losses in the first half of 2020. This provides opportunities to sift through growth companies in challenged sectors or where selling pressure has been overdone as potential candidates for the portfolio.
A better than expected May jobs report and record monthly retail sales growth provided a bid to more cyclical and value-oriented areas of the market. Such conditions boosted portfolio performance but could prove elusive if states now being hit by COVID-19 are forced to reinstate restrictions on business activity. Typically coming out of recession, the market experiences a shift in leadership. It is difficult to gauge what the winning factors will be, but we do not believe the current portfolio positioning can hold through a full business cycle. Correlation among asset classes is currently high: when fixed income is moving in the same direction as equities that indicates a period of stress which usually does not last long. Accordingly, we have added cyclicality to the portfolio to be more leveraged to a recovery in revenue and earnings once conditions normalize.
One thing is certain, recessions have consequences. We feel that it is still very early days in truly understanding one of the largest economic drawdowns we have ever witnessed. Typically, excess capacity in every industry is cleared out, purchase decisions are elongated, and savings rates go higher. All three of these consequences will have a lingering effect on the high-water mark of pre-COVID-19 economic growth.
The ClearBridge Large Cap Growth Strategy underperformed its Russell 1000 Growth Index benchmark during the second quarter. On an absolute basis, the Strategy had gains across the 10 sectors in which it was invested (out of 11 sectors total). The leading contributors to performance were the IT and consumer discretionary sectors.
On a relative basis, overall stock selection and sector allocation detracted from performance. Specifically, stock selection in the IT, consumer discretionary and financials sectors and an underweight to IT had the most significant negative impacts on results. On the positive side, stock selection in the health care, consumer staples and materials sectors contributed to relative performance.
On an individual stock basis, leading individual contributors to absolute returns in the second quarter included positions in Amazon.com, Apple, Facebook, Microsoft and Adobe. Ulta Beauty was the lone detractor on an absolute basis.
In addition to the transactions mentioned above, we sold Carrier Global and Otis Worldwide following their spinoff from portfolio holding Raytheon Technologies.