Outside the Box: The stock market is too optimistic about a quick economic recovery

But if the states experiencing surges of coronavirus infections are forced to reinstate restrictions on business activity, these conditions may end, fast. While much of the U.S. stock market is discounting for the perceived pandemic recovery, we believe economic recovery will be more gradual.

Volatility has remained high through the equity rebound in the face of several key uncertainties: the trajectory of the COVID-19 virus as a second wave of infections hits states that 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.

First-quarter earnings are now meaningless. Enterprise budgets are due to be cut across the board as companies reassess revenue assumptions in a very uncertain environment.

Market prices have gotten ahead of the fundamentals, so those expecting a short-term V-shaped economic recovery may well be disappointed. The road promises to be long and challenging, the likeliest winners being patient, long-term investors willing to ride the waves. 

The pandemic has accelerated investment trends already underway that should continue for years to come. As a result, since March, we have been repositioning for the post-COVID environment, targeting companies that can deliver above-average growth in the next three to five years, as opposed to the next six to 12 months.

It is too difficult to confidently predict how and where equity markets will move in the short term.

Digital transformation was already a priority investment for many companies pre-COVID, but the sudden shift to enable widespread working from home — with all of the communication, security and data needs that go with it — made technology spending an immediate business-critical consideration. Amazon.com AMZN, +2.64%, Splunk SPLK, -2.67% and Palo Alto Networks PANW, +1.79% are all beneficiaries of the explosive growth of cloud computing adoption.

The COVID-19 impact is also obvious in the growth of over-the-top content consumption. Disney+ DIS, +0.99% has benefited from more time spent at home and a search for entertainment to fill the gap left from live sports. This has come partly at the expense of traditional cable companies, where cable cord-cutting has accelerated.

Also, while consumer shopping patterns have been moving from offline to online retailers for years, the growth at Amazon and Costco COST, +1.30% are testaments to this trend’s acceleration. All the benefits that accrued to these companies over the last six months probably will not continue, but some consumer shopping patterns will permanently shift with marked long-term impacts.

Off-mall retailers who pivoted quickly to “buy online, pick up curbside” or already invested in an omnichannel offering are also better positioned than traditional mall retailers. U.S. mall traffic has been in decline, but CoreSite estimates that U.S. retailers could announce 25,000 store closures in 2020, a meaningful increase in the pace of closings versus prior years. 

Retailers such as Ulta Beauty ULTA, +0.73%, the cosmetics and skin care retailer, with its omnichannel capabilities and strong balance sheet, are positioned to take share from less-well-positioned retailers as the economy starts reopening. Home Depot HD, +2.42% has been investing in online capabilities for several years and is reaping the benefits: online revenue growth spiked to 79% in this year’s first quarter, up from 21% in the second half of 2019.

One thing is certain — recessions have consequences. It is still early to understand the full impact of one of the largest economic drops ever witnessed. Typically, excess capacity in every industry is cleared out, purchase decisions elongate and savings rates rise.

These factors should have lingering effects on the high-water mark of pre-COVID-19 economic growth, but there will be ample long-term opportunities for smart — and patient — investors.

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Margaret Vitrano manages the ClearBridge Large Cap Growth Fund. Its holdings included Amazon.com, Splunk, Palo Alto Networks, The Walt Disney Co., Costco, Ulta Beauty and Home Depot as of July 29.