Stock market uncertainty is as high as I can ever recall. The pandemic, economic shut-down and civil unrest have all hit at the same time. Still, the US stock market is within 5% of it’s all-time high from February. How can this be possible? Puzzling. Let’s break it down.
Below I outline the top 3 reasons for the rally, challenges for the market going forward and a few expert opinions. I will use a briefing type format where I focus on facts and provide links to article if you wish to dig into any of the details. Let’s get started.
What is driving the stock market rally?
• Jobs: The jobs report on June 5 showed non-farm payroll rose by 2.5 million in May. Unemployment fell to 13.3%. Article here.
• Stimulus: Stimulus totaling $6 Trillion or 25% of the US GDP has been deployed. The fiscal stimulus, low interest rates, federal reserve liquidity and asset purchases are driving up demand for stocks. NY Post article here.
• Reopening Enthusiasm: All 50 states have begun reopening. New Coronavirus cases in the US are on the decline. See: Reopening America here.
Big challenges going forward
• Permanent Unemployment: The total number of permanently unemployed is growing. From the June 5th jobs report, permanently unemployed workers rose 295,000 to 2.3M. More concerning data from a recent company survey shows a third have implemented hiring freezes and roughly half are considering layoffs. See CNBC article here.
• GDP Hit: Damage to the economy is large. Q2 GDP is expected to be down -53.8%. This according to the GDPNow estimate for June 4th from the Federal Reserve Bank of Atlanta. This would be the largest GDP decline ever. Recovery takes time. When consumers become fearful they hold cash. In February the personal savings rate was 8.2%. In April it jumped to 33%. Click here to see personal savings rate. Click here for Atlanta Fed GDPNow forecast.
The Congressional Budget Office projected that Coronavirus will reduce GDP by $15.7 Trillion from 2020 – 2030. They estimate an inflation adjusted 3% decline over that period. My expectation is that earnings will not recover until 2022 or 2022. However, US stocks typically bottom well before the recovery. Details here.
• Downward Earnings Revisions: Earnings estimates continue to be revised downward. Most companies are not providing guidance. Still during April and May, analysts cut their estimates for Q2 earnings by 35%, the largest in history. If we look back at 2000-2003 and 2008-2009 recessions, the market did not bottom until the earnings revisions slowed and companies had completed write-offs. See Factset article here.
As a case in point, take Apple. Apple is trading at an all time high of $330 as I write this post. According to Zacks Research, earnings estimates for 2020 have come down just 5% from the beginning of the year. Apple has not provided any guidance as it typically does.
S&P 500 is very expensive based on 2020 earnings
• S&P 500 companies generated $139.47 / share in 2019. Current estimates for 2020 and 2021 are $90.33 and $142.90, respectively. See S&P estimates here.
• The forward PE ratio as of June 5th for the S&P at $3193.33 is 35 X. The forward PE ratio is above the peak in the ’08 – ’09 recession and the ’00 ‘-03 recession. This assumes no more earnings downgrades and a full ‘V’ recovery in earnings by 2021.
Expert Opinions
• Jeremy Grantham said, markets are lost in ‘one-sided optimism’. Jeremy is the founder of GMO and is known for having made correct calls at market turns in the past. GMO cut it’s equity weight in its largest fund from 55% equity to 25%, close to the low during the financial crisis of 2008, according to FT. FT article here.
• Warren Buffet / Birkshire Hathaway held a record $137 Billion in cash at the end of March. During Birkshire’s annual meeting on May 2nd, Buffet said, ‘We have not done anything because we haven’t seen anything that attractive’. Cash position detailed here.
• Dr Ed Yardeni has a price target of 2900 for S&P 500 by year-end and 3500 by mid-year of 2021. He anticipates that we will have more of a ‘swoosh’ recovery then a ‘V’ recovery. His forecast is that GDP will not recovery until 2022.
What kind of puzzle picture does this give us?
• From the discussion above, we can see that there is a wide range of possibilities both positive and negative that are driving uncertainty.
• Based on the current price, the market is very expensive. It is pricing in a ‘V’ shaped rapid recovery. In addition, stimulus and low interest rates are likely driving up demand for risk assets (US equities).
• Given uncertainty in earning and high prices, caution is still recommended. Capital preservation for those in or close to retirement is very important. For portfolio holding excess cash, given valuations we recommend withholding increases in equity allocation until the Q2 earnings are available.