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The stock market rally continued with only a minor hiccup in the third quarter. Despite a September swoon that saw big name technology issues sell off, the Nasdaq-100 Index continued its reign of dominance over broader large-cap indexes, powering to a 12.6% total return during the quarter compared to an 8.9% gain for the S&P 500 Index. The Nasdaq-100 Index’s outperformance continued a long-term trend that has seen it return 20.4% on an annual basis for the 10-year period ended September 30, 2020 against a 13.7% annual return for the S&P 500 Index over the same period.
Tesla continued as one of the most interesting stories in finance during the third quarter, accelerating to an all-time high at the end of August in the wake of a five-for-one stock split that saw implied volatility on its short-term options shift into ludicrous mode. The euphoria ran into a temporary roadblock on September 8 when the stock fell 21% in a single day after the S&P 500 Index Committee elected not to add the issue to its benchmark index. Despite the large one-day drop, Tesla returned an eye-popping 98.7% during the third quarter.
The Tesla decision shined a spotlight on the nebulous process employed by S&P Dow Jones Indices to select constituents for the S&P 500 Index. What began as mild criticism of its index construction process turned into a black eye on September 21 when federal prosecutors charged a senior index manager at S&P Down Jones Indices with participating in an insider trading scheme based on non-public information regarding which stocks would be added to the S&P 500 Index. The incident seems likely to draw regulatory scrutiny to one of the last unregulated bastions of the investment management industry.
The strong performance of large-cap equities belied uncertainty in the real economy as the expiration of CARES Act enhanced unemployment benefits pushed U.S. household income down 2.7% in August compared to a month earlier (albeit to levels consistent with the pre-pandemic trend). Unemployment figures remained elevated but stable with the September 26 weekly print coming in at 837,000 initial jobless claims.
Meanwhile, New York State Comptroller Thomas DiNapoli released an audit on September 30 suggesting that as many as 50% of New York City’s bars and restaurants could close for good within six months due to the COVID crisis. Reflecting widespread joblessness and a COVID-driven trend toward suburban and exurban living, apartment rents in New York City were 8.5% lower in the third quarter compared to a year earlier. Other large coastal cities that have been hit hard by the pandemic saw similar declines.
With hopes for a second stimulus package mired down in Congress, other parts of the leisure and hospitality industry remain in dire straits. On October 1, American Airlines and United Airlines announced they would begin furloughing 32,000 employees following the expiration of a $25 billion federal payroll support package on September 30. And Las Vegas remains a ghost town (not the tourist trap kind), with its convention business nonexistent and 57% less visitor volume in August compared to a year earlier.
Third Quarter Performance by Category
While the third quarter provided smaller gains for income investors than the second quarter, returns were generally favorable across the range of income-oriented asset categories. The table below provides return data for major income-oriented asset categories for the period from July 1, 2020 through September 30, 2020.[1] Also included are returns for the Nasdaq 7HANDL Index and Nasdaq 5HANDL Index, two multi-asset indexes of ETFs. Every income-oriented asset category but one earned positive returns during the quarter.
[1] Returns for each asset category are based on the returns of the constituent(s) in the Nasdaq 7HANDL Index representing that category.
As was the case in the second quarter, the core equity category performed the best on an absolute basis, returning 11.3% during the third quarter. The preferred securities category outperformed every other category on a risk-adjusted[1] basis, returning 6.8% during the quarter against an annualized standard deviation of 5.6% (compared to an annualized standard deviation of 22.5% for the core equity category). Following a relatively poor second quarter, the dividend equity category enjoyed a solid rebound, returning 10.3% with significantly less volatility than the core equity category as investors grew more comfortable with the stability of dividend payouts going forward. The Nasdaq 7HANDL Index and Nasdaq 5HANDL index, which incorporate all the income-oriented asset categories, returned 4.2% and 3.6% for the quarter, respectively.
After a stellar second quarter that saw it trounce every other income-oriented category on both an absolute and risk-adjusted basis, the MLP category reverted to its long-term trend as the worst performing category. MLPs were not only the only income-oriented asset category to earn negative returns during the quarter, but also did so with more volatility than any other category. For long-suffering MLP investors, the hits keep coming.
Long-Term Performance by Category
The long-run picture continued to illustrate the power of diversification. The table below provides return data for the same asset categories for the period from January 1, 2009 through September 30, 2020. The highest total returns came from riskier asset categories, with core equity leading the pack. The highest risk-adjusted returns, however, were generated by the indexes of ETFs offering diversified exposure to all the asset categories.
[1] Risk-adjusted returns are calculated by dividing annualized return by annualized standard deviation.
Fourth Quarter Outlook
While much of America focuses on the upcoming presidential election, the nation’s response to the COVID crisis remains the biggest threat to economic growth moving forward. Prospects for a successful vaccine remain dim in the near term, and questions remain about how quickly production could be ramped up in the event one is discovered. Meanwhile, COVID outbreaks in the Brooklyn and Queens boroughs of New York City prompted Mayor Bill De Blasio to announce the likely impending shutdown of nonessential businesses, including public and private schools, in nine zip codes. For battered small businesses and hospitality workers, the move promises more pain to come.
With CARES Act enhanced unemployment benefits having expired, a tepid recovery in key employment sectors and the prospect of further lockdowns suggests personal income will continue the downward trend begun in August. Hopes for a new stimulus deal before the November 3rd election remain elusive. President Trump would no doubt benefit from such a deal, making it unlikely Democrats will compromise on demands that the conservative wing of the GOP finds objectionable. For Democrats, polls and betting markets suggest the likelihood of retaking the presidency and the U.S. Senate, outcomes that would likely lead to House Speaker Nancy Pelosi getting most if not all of what she wants in the lame duck session or from the next Congress.
With a poor debate performance, unfavorable polling and a campaign thrown into turmoil by his own COVID-19 diagnosis, the reelection of President Trump looks increasingly unlikely. Markets appear nonplussed by the likelihood of a Joe Biden presidency, suggesting that the prospects for a massive fiscal stimulus package outweigh concerns about how the candidate’s tax and regulatory proposals might influence corporate earnings.
Nevertheless, it is worth remembering that on October 7, 2016, the infamous Billy Bush tapes of then-candidate Trump leaked, leading most pundits to write his political obituary. By October 10, his betting odds of winning the 2016 presidential election had fallen to 14% according to RealClearPolitics. As of this writing, following perhaps the worst week of his campaign, the betting markets continue to give President Trump a 37.5% chance of winning the 2020 presidential election. Probably the worst near-term outcome for investors would be a contested election result that leads to civil unrest and further delays in passing a fiscal stimulus package. Income investors should continue to protect themselves from volatility with well-diversified portfolios that seek to protect against downturns and maximize risk-adjusted returns.
