Sector Focus In The New Environment

The pandemic panic engulfed the financial markets in late March, culminating in what appeared to be the capitulation phase.  Now, as we indicated in our previous commentaries, a change in direction seems underway as the equity market has rallied significantly over the last month.  This move has been supported by massive monetary stimulation and an expanding fiscal safety net.  Within the market, a number of stocks have managed to make new highs, others have recovered somewhat, while some languish with anemic responses.

As earnings season unfolds and a greater understanding of the government shutdown emerges, market participants are adjusting their expectations while anticipating the lessoning of the government shutdown grip.  The process has begun, and some states are beginning to reduce stay-at-home orders.  However, it will not be symmetrical, with some locales moving earlier and others later, and no consistent patterns emerging.  Consequently, a positive economic benefit will be sporadic.  Not until most of the restrictions are essentially lifted are we likely to see a broad uptick in economic activity.

In this setting, focusing upon the sectors and themes that should emerge as net beneficiaries (as well as those that do not face headwinds) should offer the best risk/reward possibilities.

The post-COVID-19 shutdown will have many new and changing characteristics to it.  Some trends will fade back to pre-virus conditions and others will bring new growth opportunities.  Avoiding the struggling sectors/stocks which may appear to be value propositions could be productive given the sporadic nature of the recovery and the unknown risks associated with it.  Those stocks that particularly depend upon government support and are tied to the travel/entertainment industries still appear quite vulnerable.  Segments of retail, many of which were at risk before the virus, will be struggling.  Damaged balance sheets are becoming a growing concern and a timeline for recovery for such companies is not known.

The value vs. growth approach that has dominated investor thinking for years continues to break down.  This trend has been underway for at least the last decade and has intensified because of COVID-19.

The two sectors that we have focused on for some time, healthcare and technology, are beneficiaries.  Healthcare, which was so disparaged before the virus shutdown, is undergoing a renaissance.  The expanded needs are being recognized, the innovation is being harnessed, and the growth rates are ticking up.  The government/private collaboration is unprecedented and is likely to persist for the foreseeable future.  Pharmaceuticals, biotechnology, medical devices, therapeutics, testing, and other healthcare services are just a few areas that are seeing expanded demand that should remain so in the new environment.  The segment of healthcare that is struggling are hospitals.  Many have anemic occupancy due to restrictions on surgeries and other procedures.  This situation will remain problematic and will not be alleviated until restrictions are removed.

Not all sectors will respond at the same time, but the tailwinds are there.  Technology, at the heart of our ability to manage our way through this crisis, has seen increased demand for services and products across almost all segments:  e-commerce, cybersecurity, streaming, data analytics, artificial intelligence, and cloud computing.  Even traditional stocks like Procter & Gamble and Pepsi have been revitalized during this period.

As we emerge from the lockdown, greater scrutiny of the process will occur.  Not only will there be a greater understanding of the economic damage that the draconian methods produced, but also the increased non-virus healthcare and social costs.  Furthermore, the models used to predict the outcomes of the pandemic, thus leading to many of the methods of mitigation and the economic fallout, will be scrutinized.  Some will be discredited.

The investment landscape will be changing in many ways.  The failures of many of the popular investment vehicles will become apparent.  Volatility has brought about the demise of many quant models.  For example, Credit Suisse shut down its computer-run hedge fund QT ($519 million in assets).  Also, models for program trading, hedge funds, algorithms, and very specialized ETFs have failed.  Many of the mathematical relationships break down in periods of high and unexpected volatility, such as the collapse of Long-Term Capital in 1998 and Portfolio Insurance in 1987.

At some point the massive liquidity that has been put into the economic system, with continued support from the central banks around the world, will need to find a home.  Equities remain a preferred choice, but not all of them.