he last six months have provided an object
lesson in the perils of taking the world as it is for granted — something
we in the comfortable West have been guilty of for far too long
— and
assuming that people’s lives, institutions, and societies will continue
pretty much as before, albeit while enduring the normal vicissitudes of
life. In fact, no one knows what the future holds, whether in matters of
economics, investing, or the real world. In our own sphere of
competence, for example, last January’s end-of-year market commentary
focused on the longevity of the bull market since the Financial Crisis,
and analysts pondered what it would take to derail it. With so much
loose monetary policy among the major central banks, they were hard
pressed to see any reason for financial assets not to remain in favor.
At the same time, however, it was widely acknowledged that prices and
valuations left the markets vulnerable to significant but unquantifiable
downside risks in the event of unexpected political/economic setbacks.
Meanwhile, initial reports of a new illness
spreading in China gradually entered the public consciousness, but until
cases began to appear in Germany and other Western countries, the news
was met more with curiosity than real concern. Some epidemiologists were
sounding the alarm, but few lay observers suspected that a pandemic of
historical proportions was brewing. Complacency and denial about the
SARS-CoV-2 virus muddied the waters, but once the potential seriousness
of the public health threat dawned on participants, the reaction in the
financial markets was swift and decisive. Fear of an open-ended economic
collapse caused a worldwide equity market sell-off. In the U.S. events
that could only be described in extreme terms
— “quickest selloff in
history,” “sharpest single-day decline,” “worst month since 2008,”
— provide a glimpse into market psychology during the worst days of the
panic. Commodities were hit badly as well, reflecting an expected demand
collapse; petroleum futures prices, for example, briefly fell to an
unprecedented minus $40 per barrel.
Moving forward a mere two months: on June 3 the
S&P 500 completed the best 50-day upswing in the history of that index,
and it approached the all-time high reached in February. The NASDAQ, in
fact, surpassed its previous zenith and ended June about 4% above its
pre-plunge high of February 19. June 30 ended the best quarter for the
major averages since 1998, as the Dow Jones Industrials rose about 18%,
and the S&P nearly 20%. Reflecting the strength in the technology sector
that has been responsible for a substantial part of stock market gains
in recent years, the NASDAQ spiked over 30%. Modest but nonetheless
surprising early progress in the development of vaccines and treatments
for COVID-19 helped to spark a change in sentiment. Relatively positive
economic news contributed to the move into equities; statistical
releases showed that the pandemic’s impact on employment, housing, and
industrial production, while severe, has not been as dire as feared in
March. Also helping matters greatly was massive intervention by central
banks
— including a $3 trillion increase in the size of the U.S. Federal
Reserve’s balance sheet
— and the adoption of major fiscal stimulus
programs in the U.S. and Europe designed to support employment and help
businesses survive the downturn. In the midst of a panic one tends to
forget how effective such policies can be, but large-scale monetary and
fiscal responses do tend to have a positive impact in mitigating the
contraction in business activity an economic crisis brings in its wake.
It goes without saying that most observers
looking at the markets in mid-March would not have conceived, let alone
predicted, such a turn of events. Indeed, sentiment towards the markets
among professional money-managers had collapsed; surveys showed that
economic growth expectations had fallen to the lowest mark in 25 years.
Few expected a rebound anytime soon. Hindsight demonstrates once again
just how unwise it is to let big, traumatic events guide your judgement
and lead you to make rash moves in the throes of a panic, such as
selling in an attempt to “avoid further losses.” Even experienced
professional investors forget this wisdom; during the second quarter
some hedge funds wagered on a continuation of the market downdraft
(through operations that, in effect, sell securities short) and learned
to their chagrin that one bout of market trauma is not necessarily
followed immediately by a second. Over the long-term, economies grow and
stocks generally rise; crises, even pandemics, tend to be relatively
short-lived events
Bring Back The Stocks
While policies such as the Paycheck Protection
Program and expanded unemployment benefits have been helpful in
sustaining workers through this downturn, many businesses, large and
small, have been hard hit. This has necessitated a variety of
cost-cutting measures, such as layoffs, production cutbacks, salary
reductions, and, notably during this recession, working from home. In a
touching show of solidarity with their employees, some public company
CEOs and directors have accepted significant salary cuts as well (50% in
some cases), but before anyone sheds a tear over executive penury, we
would point out that many of them have a backstop unavailable to the
average worker: grants of additional stock options. Given the
share price declines in recent months, the holders of these options
could see outsized gains when prices recover, as they have since March,
that are well worth the temporary sacrifice in take-home pay. We doubt
that public shaming for this behavior would have much of an impact on
such people, but we think it is a good place to start.
It is worth pointing out that once upon a time,
average employees did enjoy the benefits of ownership of their company’s
stock through profit-sharing plans, which are now out of favor. It has
been estimated that had one of the big online retailers followed
employee benefit policies common in the past, its staff members would
now own on average over $380,000 worth of their company’s shares.
Much like the ten-year bull market that emerged
from the Financial Crisis beginning in 2009, the notable rise in stock
prices since March has been met with a great deal of skepticism. It has
been called the “Terminator Rally,” after the unstoppable cinematic
cyborg. One well-known fund manager said, “the chutzpah involved
in having a bubble at a time of massive economic and financial
uncertainty is substantial.” In a recent survey, four of five managers viewed U.S.
equities as overvalued, the highest percentage since such polling began
in 1998. A similar poll in May found that 70% thought the upswing that
began in March was simply a “bear market rally” doomed to
reversal. In mid-March, near the bottom of the market rout, sentiment
among the managers had collapsed and their allocations to equities
suffered the biggest decline on record. Interestingly, in the midst of
the rout one broker’s “Bull and Bear Indicator” produced a “buy signal.” It was
largely ignored because no one believed the numbers. “A sustained rally
requires further macro and market policy moves, plus the belief that the
virus is peaking in Europe and the U.S.,” said one fund investor. Sounds
logical, but such requirements are seldom met when the world is
collapsing around you, and the probability is high that when conditions
come to be more to that fund manager’s liking, the markets will be
significantly higher.
Although we always take such commentary with a
grain of salt, it is nevertheless important to address one complaint
frequently mentioned nowadays, namely that there is a “gap between
share prices and economic fundamentals.” We would agree that the stock market
is considerably less interesting than three months ago, but the
assertion by some observers that equities are overvalued now more than
ever before seems extreme.
Numbers do indeed tend to support the alarmist
view. The relationship between index values and underlying aggregate
earnings (a common measure of valuation) lies within the top 10% of its
range historically. Based on “forward,” or forecasted earnings, the S&P
500 trades at 22 times (it was at 19 times at the market peak in
February, and that was the highest P/E since 2002). Using the
“cyclically adjusted” earnings figure (which smooths periodic earnings
volatility), the index is valued at 30 times, almost twice its long-term
average. At 1.9%, the S&P’s dividend yield is also at the lower end of
its historical range.
While seemingly expensive, it is important to
note that the figures are somewhat distorted by peculiarities of index
construction. Notably, five big technology companies currently account
for 20% of the S&P 500’s value (the entire tech sector now weighs in at
30%), and thus have an oversized impact on that valuation-weighted
index. The strength of this small number of names explains much of the
index’s rise this year (toward the end of June, even after the historic
rally, over half of the index components were down by more than 10% for
the year). Earnings estimates have also come down — not surprising given
the current economic uncertainty
— and this inflates the forward-looking
valuation figures. Finally, regardless of index valuation, there have
been a number of industries and individual companies selling at more
reasonable prices.
Earlier we alluded to surveys of professional
investors going back to 1998. At the end of that year the S&P 500 stood
at 1,279.64. At June 30, 2020 it had risen to 3,100.29, or 142.3% (not
including dividends or their reinvestment). So, over two decades,
through bubbles, financial crises, health crises, wars, and temporary
panics, the stock market produced significant results for genuine
investors. The record also indicates that market viewpoints, while
entertaining to read, are mostly short-term in nature and really have no
relevance to investing, which is inherently long-term.
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