Unprecedented events in the global economy have had a strange effect on the stock market even as indices have fully recovered from the COVID-19 shock, but performance has diverged wildly among industries. Uncertainty over the next year of public health and economic activity makes it impossible to know which types of stocks are likely to thrive or suffer, but investors still have to build a portfolio that works in any outcome. Here is how you can devise a portfolio that can withstand the turbulence of coronavirus.
Winners and losers from COVID
Travel and hospitality companies have been severely hampered as people stay home and avoid crowds. Falling interest rates and concerns over loanee health have hit the financial sector. Real estate has been battered by concerns of shrinking demand for office space and the inability of tenants to meet lease obligations. The energy sector has also been crushed as oil prices fell due to feuds among major suppliers.
Despite all that negativity, the market has erased the losses of March and April. The S&P 500's forward price-to-earnings (P/E) ratio is near 22x, the highest level since 2001. Forward P/E is hardly a perfect metric, but it is indicative of charging valuations that are exhibited disproportionately by a handful of industries.
Valuations in the technology sector have surged, pulling the overall market up. Online retailers and e-commerce stocks have climbed with people opting to purchase goods at home. Companies that enable remote work with security, conferencing, and collaboration software, such as Zoom, have similarly benefited as employees remain remote. Entertainment and streaming platforms such as Netflix have seen major increases in traffic. Promising telehealth leaders such as Teladoc Health have also leaped forward.
What if this situation continues?
The economic ramifications will be serious if COVID cases continue and the vaccines in development prove ineffective. Curtailed economic behavior will have dire consequences for the travel and hospitality industries, as they will continue to experience cash flow issues, which would be a major problem for debt-heavy companies. Without government intervention, some bankruptcies and distressed acquisitions are likely in those industries, both of which are horrible outcomes for shareholders. This squeeze will move upstream, and real estate investment trusts (REITs) that own hospitality properties, such as Host Hotels & Resorts and Four Corners Property Trust, will struggle. Similarly, restaurant suppliers like Sysco would be in trouble if their customers go out of business or realize lower traffic.
What if the economy reopens rapidly?
Banks would benefit from interest rates ticking up, increased business and consumer lending activity, and lower default risk among loanees with healthy cash flows. Banking stocks have performed poorly this year, but they are in an excellent position to benefit from reopening.
Travel and hospitality are likely to benefit from pent-up demand, and there should be a strong period immediately following a true reopening. Nonetheless, economists are forecasting sustained high unemployment as the labor force reshuffles to new positions, which hurts consumer confidence and the disposable income that drives those industries.
Health insurance companies have enjoyed stellar months, as people stay home and reduce the number of elective and emergency procedures. Pent-up demand for elective healthcare will send more people to doctors and hospitals, but it will also pull back some of the positive results insurers have notched.
Many people will return to offices once fully reopened. However, there is speculation that a permanent shift to remote work has been made. A relatively small conversion to work from home would deal a major blow to demand for office space, and this would continue to support the conferencing, security, and collaboration software stocks.
Building a portfolio for either outcome
With the winners and losers for each scenario understood, investors must then determine how to craft a portfolio that can thrive in either situation. However, today's soaring valuations in some industries, paired with serious financial health issues in others, create excess risk to the downside.
Alternatively, investors can identify the COVID winners that will also experience solid fundamentals post-recovery, as well as resilient, quality stocks that have not experienced skyrocketing valuations in recent months.
Payment services such as Visa have kept pace with the market and should see no slow-down as the fintech world continues to evolve. Diversified healthcare companies such as Johnson & Johnson have similarly matched the S&P 500's expansion and are likely to have steady demand moving forward. Investors might hesitate to embrace the prices of Amazon and Shopify, but both are in prime position to benefit from a sustained shift toward e-commerce.
While the tech sector has spiked to historically high valuation levels, some members with solid fundamentals and long-term catalysts have not experienced the same leap. Suppliers of hardware for the 5G rollout, such as Skyworks and Corning, are still in position to benefit over the next several years and are not priced at nearly the premium of Zoom. Banks will continue to struggle in the short term, but adjustments made after the 2008 financial crisis placed them in a healthier position to weather the current storm. The banking sector as a whole isn't going to disappear in the next few years, and major banks Wells Fargo, Citi, and Bank of America are all down around 30% this year. These stocks pay a dividend and will be in a strong position to outperform the market upon recovery.
The best COVID-optimized portfolios will retain diversification, with more exposure to quality stocks that have not priced out medium-term upside potential. Chasing high fliers that are bound to see a pullback in demand post-recovery could sink a portfolio when valuations come back to Earth. Similarly, companies that are suffering under the current conditions could be classic value traps if economic recovery is a longer-than-expected process.