The Stock Market Could Head Higher Despite the Contraction in GDP

The U.S. economy entered 2020 with high hopes of delivering stellar growth, only to find itself in the deepest recession in recent memory within just a couple of months. The second-quarter economic performance of the country will make history, but for all the wrong reasons. The U.S. Bureau of Economic Analysis revealed that real gross domestic product has decreased a staggering 32.9% in the three months ended June 30.

Source: U.S. Bureau of Economic Analysis

Commenting on the reasons behind this sharp decline, the bureau wrote in its quarterly statement:

“The decrease in real GDP reflected decreases in personal consumption expenditures (PCE), exports, private inventory investment, nonresidential fixed investment, residential fixed investment, and state and local government spending that were partly offset by an increase in federal government spending. Imports, which are a subtraction in the calculation of GDP, decreased (table 2). The decrease in PCE reflected decreases in services (led by health care) and goods (led by clothing and footwear). The decrease in exports primarily reflected a decrease in goods (led by capital goods). The decrease in private inventory investment primarily reflected a decrease in retail (led by motor vehicle dealers). The decrease in nonresidential fixed investment primarily reflected a decrease in equipment (led by transportation equipment), while the decrease in residential investment primarily reflected a decrease in new single-family housing.”

Odds are stacked against the S&P 500, but a deep dive into historical performance statistics and the expected improvement in investor sentiment suggests the market is likely to outsmart many investors once again, the same way it did when the index bottomed on March 23.

The power of the big five will remain intact

Tech stocks dominated the decade-long bull run that lasted through the beginning of this year, and the success of the five largest companies representing the S&P 500 Index was the primary reason why stock prices continued to reach new highs in the recent past. These companies are:

1. Apple Inc. (AAPL, Financial)
2. Microsoft Corp. (MSFT, Financial)
3. Amazon.com Inc. (AMZN, Financial)
4. Facebook Inc. (FB, Financial)
5. Alphabet Inc. (GOOG, Financial)

In April, Business Insider reported that the combined market capitalization of these companies as a share of the total value of the index has never been as high as the levels seen this year.

Source: Business Insider.

In comparison to a long-term average of just 14%, these companies accounted for more than 20% of the index value in late-April. According to data from Eikon, the current reading is 21%, which is an all-time high. Wall Street analysts have continued to believe in the ability of these five players to grow their revenue and earnings exponentially for many years as well.

Going by the above data, it would be reasonable to assume that the market will continue to head higher if big tech companies can maintain their positive momentum. Below are the earnings growth projections for this year for both the market and the leading tech companies.

Source: Eikon

The five largest companies representing the index are expected to perform better than the market from an earnings perspective, which is likely to result in these stocks outperforming the index in the foreseeable future. From a market sentiment perspective, investors will find solace in most of these companies due to their resilience to the current economic downturn. This, in combination with better numbers than the index, will most likely lead to an extension of the current market rally well into 2021.

The Fed will only stop when the U.S. gets back on track

Trillion-dollar stimulus packages and expansionary monetary policy decisions have been at the center of the market recovery. During the latest Federal Reserve meeting on July 29, policymakers painted a bleak outlook for the American economy and reffirmed their commitment to keeping interest rates near zero until there are promising signs. In its official statement following the meeting, the Federal Open Market Committee wrote:

“The path of the economy will depend significantly on the course of the virus. The ongoing public health crisis will weigh heavily on economic activity, employment, and inflation in the near term, and poses considerable risks to the economic outlook over the medium term. In light of these developments, the Committee decided to maintain the target range for the federal funds rate at 0 to 1/4 percent. The Committee expects to maintain this target range until it is confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals. To support the flow of credit to households and businesses, over coming months the Federal Reserve will increase its holdings of Treasury securities and agency residential and commercial mortgage-backed securities at least at the current pace to sustain smooth market functioning, thereby fostering effective transmission of monetary policy to broader financial conditions. In addition, the Open Market Desk will continue to offer large-scale overnight and term repurchase agreement operations.”

It is clear that money will continue to flow into U.S. consumers and businesses at a record pace as a result of the extraordinary monetary and fiscal policy measures set in motion to mitigate the impact of the recession. The opportunity cost of underestimating the power of the Fed could run into double-digits, which is evident from the 44% gain in the S&P 500 Index from March 23 to July 30.

Takeaway

The American economy is going through one of its most difficult phases. The record contraction of the GDP in the second quarter could turn out to be the tip of the iceberg. On the back of these disappointing data, an investor might want to run for cover as it seems the best decision amid the challenging macroeconomic conditions. A careful analysis of the expected financial performance of the five largest components of the S&P 500 Index, however, should create reasonable doubt whether the broad market will follow the economy or not. To add some perspective, all three major indexes in the U.S. have staged a spectacular recovery since late-March even though most businesses remained in lockdown due to mobility restrictions imposed by state governments.

There is a possibility of a similar phenomenon occurring in the coming months, and investors should carefully factor in this possibility before deciding whether or not to remain on the sidelines until the economy recovers. Evidence suggests that tactically investing in cash flow-positive companies with strong balance sheets is the best strategy to navigate this crisis and generate alpha returns.

Disclosure: I own shares of Facebook.

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