A Bull Market Looking for a Cause?
by Jim McElroy, firstname.lastname@example.org
With three quarters behind us and one quarter left, 2020 has already been an historically unpleasant year. With 200,000 plus COVID 19 deaths (1,000,000 worldwide), alphabet-busting numbers of hurricanes, record-setting wildfires in western states, continuing protests and riots in our cities, an increasingly ugly election cycle and the highest rate of unemployment since the Great Depression, it’s hard to imagine how investors in the quarter just ending could have mustered enough optimism to buy stocks, much less fuel new highs in an already six month old bull market. But here we are, with a bear market bottom behind us, a trailing quarter growth in the S&P 500 of 8.5% and the best trailing two quarter growth (30.1%) since 2009; even including the first quarter bear market, the year-to-date growth in the S&P 500 was still positive (4.1%).
Has all the stress made the market delirious or is there some method behind this madness? Markets have been known to succumb to madness — we see it whenever wild rumors create buy or sell orders with panic-driven high transaction volumes — but these are usually periods of short duration. Despite some evidence to the contrary, we don’t believe that the market has completely lost its way. Ahead of itself, perhaps, but not deranged.
A major source of stress for investors in the coming quarter is the election in November. No matter what one’s political affiliation, the uncertainty of elections alone can create greater than normal volatility. This is especially the case during this COVID-19 year when an anticipated higher percentage of absentee and mail-in ballots could delay the tabulation of results well past Election Day. And we should probably expect that with delays in naming winners there will be claims of miscounting, false ballots, unjustified voter disqualifications and foreign interventions in the election process. Oddly enough, the history of markets following elections — whether the result is a change in regime or a victory for the incumbent — suggests that, following a short period of heightened volatility, the markets tend to return to their pre- election path. Our judgement is that fears about the outcome of the election are mostly baked into the current markets: after the votes are counted, the winners announced and the results digested, the market should settle back into its prior state.
It’s a commonplace observation that market valuations are determined by future expectations. In addition to the election, the other great stress for investors and cause of much uncertainty about the future is the Coronavirus pandemic. But in at least one respect, the virus has clarified the task of discerning near future expectations: since it was the sudden outbreak of the virus in the first quarter of this year, as well as the subsequent government responses to that virus, that caused the recession and bear market, it’s fair to assume that the near future of the global economy and its markets will hinge on the future path of the pandemic. The appearance of new bull markets in global stocks, following lows in late March, strongly suggests a market belief that the pandemic’s deleterious effects have peaked. And since it appears that infections are decelerating, it’s plausible to believe that total lockdowns in the future will be rare and that effective vaccines will be available during the second quarter of 2021. Of course, these assumptions may turn out to be incorrect — and there have been some indications since Labor Day that infections are increasing — but, for now, they seem reasonable and the bull market continues.
Overall, the pandemic’s ill effects do appear to be lessening — or businesses and the population are just adjusting their processes and habits — and the economy is showing growth after the lockdowns of the second quarter and the worst GDP reading in 40 years (-31.7%). Employment is recovering from truly jaw-dropping numbers: recent Initial Claims for Unemployment Insurance came in at 870 thousand, down from the late March peak of 6.9 million, though still well above the 211 thousand of early March; and the unemployment rate, currently a whopping 8.4%, has been steadily declining since the April figure of 14.7%. Not surprisingly, the largest component of continuing unemployment is in the leisure, travel and hospitality industries (hotels, cinemas, restaurants, sports bars, airlines, etc.), where social distancing can be devastating. The ISM Purchasing Managers Indices for both manufacturing and services, after declining into the 40s (below 50 is contractionary, above 50 is expansionary) at the beginning of the pandemic, now register 56 and 56.9, respectively. And while the Conference Board’s Index of Leading Economic Indicators is still forecasting contraction (-4.7), this is a dramatic improvement from its pandemic low (-12.5). For the sake of comparison, the LEI registered -20 at the end of the Great Recession of 2008-2009. The economy is recovering from its first quarter vertical collapse, but its return to pre-pandemic levels is taking a somewhat less than vertical path: it’s likely to be the second half of 2021 before things return to normal.
Corporate earnings, arguably the most desirable statistic for assessing the health of the economy and the stock market, showed a decline of 23.2% from the fourth quarter of 2019 through the second quarter of 2020. However, since these numbers are neither predictive, timely nor set in stone — like GDP, they’re subject to revisions — they provide little in the way of judging market expectations. Under normal circumstances, we would look at the next quarter’s and next year’s earnings expectations from Wall Street analysts, compare those to current stock prices, produce a P/E ratio for the overall market and determine if that valuation seems plausible. But due to pandemic induced dislocations, Wall Street estimates of earnings for the next twelve months are dubious. Even the companies themselves have difficulty providing earnings guidance for the year ahead. But, for what it’s worth, the P/E for the S&P 500 is 24.6 times expected earnings and 25.2 times trailing earnings: this means either that Wall Street is forecasting no earnings growth over the next four quarters or simply has no confidence in earnings estimates and is using last year’s number as a “place holder” until something like clarity returns.
An absence of earnings growth over the next four quarters or great uncertainty over the future should not describe a market trading at about 25 times earnings. The long-term average P/E of the S&P 500 is about 18 times earnings; zero growth and/or great uncertainty should produce a much lower multiple than both the average and the current P/E. It’s possible that the market is over-extended: that happens from time to time. However, the most likely cause for this elevated valuation in stocks can be laid at the feet of the Federal Reserve. In the absence of even a whiff of inflation and the presence of an economy-wrecking pandemic, the Fed has committed itself to holding overnight interest rates between 0% and .25% over the next three years and has dramatically added to its balance sheet by buying bonds, thereby driving prices up and yields down.
It may very well be that stocks are now trading much more on yield than on P/E ratios: when ten year U.S. Treasuries yield .65%, with no growth, and the S&P 500 yields 1.7%, with the strong likelihood over the next ten years of higher dividends and higher prices, there doesn’t seem to be much competition. Negligible interest rates also have the power of “telescoping” time by increasing the present value of future returns: instead of basing P/E multiples on 2021 earnings, investors may be skipping the next four quarters and focusing on 2022 earnings. TINA, or “there is no alternative”, may be an exaggeration, but it’s certainly true that there are few alternatives to stocks.
2020 to date has been a very volatile year for the stock market. It has moved from a bull market to a bear market back to another bull market, all in less than three quarters. Most of this has been due to the onset of the COVID-19 virus and the government’s seemingly draconian responses to it. While we believe that the market is an efficient discounter of the future and that the bull market is forecasting an end to the pandemic and the accompanying recession, there is little reason to believe that volatility will not continue into the fourth quarter of this year. We recommend that investors look at their long- term objectives and rebalance their portfolios accordingly. While we do not recommend over-weighting equities, we certainly would not recommend under-weighting them.
Not Investment Advice or an Offer
This information is intended to assist investors. The information does not constitute investment advice or an offer to invest or to provide management services. It is not our intention to state, indicate, or imply in any manner that current or past results are indicative of future results or expectations. As with all investments, there are associated risks and you could lose money investing.