Valuation Check: Is the market ready for a fall?
The S&P 500 hit new highs this week and it is natural to start asking, “have we recovered too much too fast”. I have received several calls asking if this recovery is real, and if we are heading for a fall. 2020 has been an exceptional year to be sure, beginning with one of the steepest market drops on record followed by one of the steepest recoveries, resulting in the shortest recession on record. In this kind of environment nothing is certain, but there are increasing signs that the worst is over for the global economy.
When we met with our clients for our annual investor conference on March 14th, we highlighted that the Virus crisis was likely to be somewhat akin to a natural disaster with steep declines and a sharp recovery. Certainly, the world had never experienced a government mandated economic shutdown, and the results were devastating. Economic data for the second quarter of 2020 were historically bad. The unemployment rate in the U.S. skyrocketed from 3.5%, one of the lowest levels on record, to 14.7% and the number of unemployed persons rose to a record 23M in April. U.S. GDP in the second quarter fell by 9.5%. The results were similar around the world with the Euro area GDP falling 12.1% and Japan falling 9.9% in the second quarter. Global production peaked at a record high during December of 2019 and fell 12.8% through April, and Global exports were down 17% through May.
However, the world had also never experienced the level of economic stimulus that has been pumped into the global economy. On March 23rd, the Fed reignited its quantitative easing program originated during the 2008 financial crisis, only this time the Fed went even bigger, buying a record $1.9 trillion in Treasuries from March through June. The Fed also began unprecedented programs to pump liquidity into the bond market, including several special purpose vehicles to purchase corporate bonds and even exchange traded funds. Congress opened the spigots too with the $2 trillion CARES Act dropping cash directly into the hands of individuals and businesses. With numbers this large it is hard to get a sense of the size of the spending. Here is one measure: the increase is government social benefits more than offset the drop in wages and salaries of 23 million Americans out of work. Not to be outdone, the European Central Bank and the Bank of Japan enacted similar measures.
The result of this level of stimulus, coupled with the staged reopening of the economy is that the economy is bouncing back incredibly strongly. Economic indicators appear to have bottomed in April and the 3rd Quarter GDP growth according to the August 18th Atlanta Fed’s GDP Now forecast is 25.6%. Unemployment has fallen from a high of 14.7% to 10.2%, and unemployed persons has fallen to 16M. Retail sales rebounded 29.9% from April through July to a new record high. Manufacturing plunged 20.1% from February through July but rebounded 15.2% through July and is now 8% below pre-pandemic levels.
As we wrote back in April the market has been ‘looking to the other side of the valley’ since April, anticipating the recovery even as economic data was looking worst. Now, despite the rebound, the economy has not fully recovered and the market is hitting new highs, as the forward-looking market anticipates continued recovery. The rally is also broadening as analysts grow more optimistic about a wider breadth of industries, not just the technology companies that have been leading thus far.
Admittedly, there is a lot of good news built into the current prices in the market. Since earnings are still expected to be lower in 2020, Forward P/E ratios, a measure of valuation, are above their record highs prior to the bear market for almost all of the S&P 500 sectors Said another way, stocks are expensive based their expected earnings levels. Therefore, stock prices imply continued economic and earnings recovery back to ‘normal’ levels. A resurgence of the virus, or other unexpected road bump, could still derail the market.
It is likely that the most rapid part of the economic recovery is behind us, and that it will take some time to fully recover. Therefore, the market is unlikely to maintain the rapid ascent of the past few months. That isn’t a prediction for a fall, but merely a realization that the fastest part of the recovery is behind us. Going forward the economy and the market will be driven, not by the daily results of the virus, or dramatic announcements of government intervention, but rather the more mundane results of corporate management and earnings releases. I for one welcome the chance to get back to a sense of normalcy.
The events of the past few months remind us that long term strategy matters. This is a good time to evaluate your risk level. Through this cycle we were able to stay on course, and even take advantage of the disruption to add value to our clients. Storms inevitably come but the right strategy can help you weather each one and still achieve your goals.