Q2 was easy for investors, just buy everything that fell in Q1. Q3 it's not so simple — What to do

Published Thu, Jul 2 20202:30 PM EDT

Despite pandemic, panic and protests, not to mention possibly the deepest recession in U.S. history, investing in the second quarter actually turned out to be not that mystifying: Just pick all the losers from the beginning of the year, plus the stay-at-home stocks that the coronavirus made popular. It all added up to a 20% second-quarter gain for the S & P 500 despite the quickest fall into a bear market in history. As the second half of the year starts, however, things get more complicated. The calculus of reopening will be difficult. How strong the gains are in the economy and employment will be hard to predict and highly dependent on the path of the virus. Valuations are elevated and volatility is increasing. It all adds up to more complicated investing puzzle ahead. "It will be a market where managers, traders, hedge funds and portfolio managers try to carve out and create pockets of certainty amid an uncertain environment that's obviously jeopardized by the virus," said Quincy Krosby, chief market strategist at Prudential Financial. "Then there is the race for the vaccine. That is what will bring us to the other side." A look at a few big second-half themes and how to invest around them: Politics and the pandemic Krosby sees two big market-moving events ahead: The continued race in the pharmaceutical industry towards therapeutics and a vaccine to treat Covid-19, all against a backdrop of a contentious political season highlighted by the race for the White House. On the virus, Krosby said to keep watch on companies making announcements regarding treatments and vaccines. "Those headlines over the course of the summer and fall are going to be crucial," she said. "Those announcements will be market moving and will broaden the market in terms of sectors." For instance, she said treatment news likely will impact consumer discretionary stocks for companies "that allow Americans to say, 'yes I can go out and engage in activity that I didn't want to without a treatment and vaccine.'" On the political side, the questions run even deeper. Markets are increasingly betting on a Joe Biden victory and a potential Democratic sweep in November that could roll back much of the measures taken during the Donald Trump presidency — namely tax cuts, regulatory rollbacks and at least the potential for major infrastructure spending. A Biden presidency likely would see money shift to companies with higher social responsibility scores. The breakup of big technology companies would increase as fossil fuels also could come under pressure, Krosby said. Health care stocks also would come into play as progressives ramp up the pressure to expand medical coverage. Dividends in fashion As companies took government money to survive the pandemic, the idea of returning cash to investors came under pressure, particularly when it comes to share buybacks. However, companies with strong balance sheets that can afford to keep the dividends coming should be popular at time when the likelihood of returns on pace with the last three months diminishes. Reduced investor confidence makes dividend payers all the more attractive, said Savita Subramanian, equity and quant strategist at Bank of America Global Research. The firm's gauge of bullishness among Wall Street strategists "is firmly in neutral territory" and serves as an indicator that even with the big Q2 rally, investors remain skeptical, she said. "This behavioral bias against equities has created an opportunity to purchase safe dividend yield at relatively low prices," Subramanian wrote in a note. "The dividend yield of the S & P 500 is now at a multi-decade record multiple of bond yields, and whereas the sustainability of dividends has come into question amid the recession, we think a significant proportion of the S & P 500 offers sustainable dividend yields." Asset management giant BlackRock also is touting dividends, warning clients against dividend cutters and stressing that "not all dividends are created equal." "We focus on quality companies with a record of sustaining or growing their dividend across time," Tony DeSpirito, chief investment officer for U.S. fundamental active equity, said in a letter to clients. "'Quality' businesses, by our definition, have higher returns on capital, strong balance sheets and positive earnings trends. Their managements have a record of sustaining or growing their dividend across time." The art of rebalancing The wild swings in the market, from a 34% plunge from Feb. 19 to March 23, followed by a 39% flip off that low, has caused major stocks-to-bonds misallocations in portfolios. Investors should remain vigilant on those moves and take action to make sure they keep in balance, said Liz Ann Sonders, chief investment strategist at Charles Schwab. "The market's very much at the mercy of virus-related news. It seems there's more upside on good-headline days than downside on bad-headline days," Sonders said. "That adds an element of grave uncertainty for investors and market watchers, because we're dealing with a health-related cause of big swings up and down — not what the Fed is doing, not earnings. We are at the mercy of headlines." That's going to translate into an economic recovery that looks like a series of "rolling Ws" rather than a U- or V-shaped move, she added. Sonders worries about an accompanying wave of "rampant speculation" that has accompanied the market bounces in a first-half that saw, according to DataTrek Research, 1% moves in either direction on 54% of trading days. The second quarter alone saw 38 such days, compared to the quarterly average of 13. For investors, that could necessitate rebalancing not annually or quarterly but rather when the wild bounces throw allocations out of whack. "The only real message that is appropriate to give investors at this point is to be as mindful of the emotion of greed now as it was two months ago or three months ago to mindful of the mindset of fear," she said. "Consider more frequent rebalancing driven more by big moves in markets and asset classes vs. rebalancing done on a calendar basis." When it comes to making choices, Sonders expects factors, like good balance sheet, cash flow and strong management will take precedence over sector picks. "That;s the best way to stay on the right side of these big swings. It allows us to add low and trim high," she said. "You don't have to pick tops and bottoms. You just have stay really disciplined over time. That's the closest thing you'll get to a free lunch."

It all added up to a 20% second-quarter gain for the S&P 500 despite the quickest fall into a bear market in history.

As the second half of the year starts, however, things get more complicated.

The calculus of reopening will be difficult. How strong the gains are in the economy and employment will be hard to predict and highly dependent on the path of the virus. Valuations are elevated and volatility is increasing.

It all adds up to more complicated investing puzzle ahead.

"It will be a market where managers, traders, hedge funds and portfolio managers try to carve out and create pockets of certainty amid an uncertain environment that's obviously jeopardized by the virus," said Quincy Krosby, chief market strategist at Prudential Financial. "Then there is the race for the vaccine. That is what will bring us to the other side."

A look at a few big second-half themes and how to invest around them: