The weekend after Memorial Day, the country finds itself besieged by widespread riots and vandalism. The reaction to a wrongful homicide is unlike any ever seen before and likely, also, a result of frustration and fear of a bleak future that many unemployed see before them. A little over 400 years ago, English poet and playwright,Shakespeare, posed existentialist questions through the protagonist of his play by the same title, Hamlet. In it, several pithy expressions, including, “To be or not to be…” are raised as the character grapples through his life’s uncertainties.
And yet, stock-market bulls cheered, the Tuesday morning after Memorial Day as S&P 500 traded above its 200-day moving average, a key technical resistance level followed by market observers seemingly unconcerned by the cascading systemic effects of a global pandemic. The lifting of lockdowns across the U.S. as well as falling numbers of coronavirus cases and slowing death rates, has fueled hopes that the worst of the pandemic is over.
Moreover, the market has been conditioned by the notion, economic activity and employment will quickly rebound to reflect normalcy and this hope is surely well founded. Wall Street economists and strategists continue to telegraph this outlook ignoring everything from a second wave of infections, withdrawn earnings guidance by a majority of companies and ongoing layoffs, even by leading firms across industries.
This sentiment was best captured by Michael Wilson, chief U.S. equity strategist at Morgan Stanley, who wrote, “We will see a V-shaped recovery for two reasons – the historic steepness of the decline in activity, and the unprecedented policy response.”
Reasons for Optimism
There are at least 4 factors fueling the equity market rally:
1. Rapid and Unprecedented Level of Policy Response by the Federal Reserve and US Congress
The Federal Reserve was the first out of the gate in cutting the Fed Funds benchmark rate to an effective zero target. They followed it up with large funding initiatives targeting all segments of the economy. Importantly, they have been able to successfully prevent the corporate and municipal bond markets from shutting down and effectively switching off much needed borrowing. This has allowed otherwise healthy businesses to secure funding and state and local governments to stay afloat as their revenue streams dry up.
Federal lawmakers followed it up in equal measure via programs to small and mid-sized businesses in distress, individuals and families and local governments, among others.
These actions have stemmed an accelerating deterioration in economic conditions and avoidance of a financial crisis; a cause for markets to retrace upwards.
Importantly, market participants have read the actions by the Fed and lawmakers, as a recognition of equity markets as an important barometer of confidence in the economy and their willingness to prop it up. The fallout of it is a pervasive frontrunning of risk, in all flavors.
- Successful social distancing and a flattening of the viral infection rate curve
For a virus that is highly contagious,even as its victims are asymptomatic for an average of 10 days upon contracting it, in the absence of widespread testing, the centerpiece of the public health response to COVID-19 is social distancing.
The Centers for Disease Control (CDC) noted that “while social distancing interventions were in place, 20% of new cases and most hospitalizations and deaths were averted, even with modest reductions in contact among adults. However, when interventions ended, the epidemic rebounded. CDC models suggest that social distancing can provide crucial time to increase healthcare capacity but must occur in conjunction with testing and contact tracing of all suspected cases to mitigate virus transmission.”
Not flattening the curve would have probably meant orders of magnitude higher deaths. It has bought time to build a sustainable way to control the pandemic, like mass testing, a “track and trace” system and eventually, effective medical treatment including a vaccine. One can therefore argue, social distancing has limited damage to the economy and, if sustained, gives it the chance to rebound quickly as measures are put in place.
- Mega Caps in Technology and Healthcare suggest these sectors have had limited impact
While the S&P 500 index is just 17% off its record high reached in February, the median stock is 28% below its high. Unlike retail, hospitality, travel, leisure, entertainment, gaming and other heavily service-oriented industries, many parts of technology and healthcare may be relatively impervious to lockdowns and their businesses mostly unscathed. Mega-caps, particularly in tech and healthcare may have similarly been able to withstand the shutdown better and their operations stand to rebound quicker than most.
The big-5 constituents of the S&P 500 certainly reflect this outlook.
- Optimism about a strong restart of the economy:
This based on the glass-half-full view that the worst is behind us and the economy can get only better from here on out. Markets look ahead, and almost all states are in stages of opening up. What we do know is that, economically, reopening will mean improvement. April 2020 will go down in history as the most economically devastating month for a long time to come, one signaled by likely market bottoms in industrial production, retail sales and the price of oil among several more and tops in others like unemployment claims. But the rate of improvement and its direction, moving toward year end is what matters. Few are going back to work at this time. More will do so over the coming weeks and months.
Equity market Valuation
Goldman Sachs Chief Equity Strategist, David Kostin states that the bank’s “baseline 2021 EPS forecast of $170 represents a best-case scenario — achievable, but definitely optimistic.” He adds that the current valuation, based on the macro model implies business steadily normalizes. If these developments transpire, “at year-end 2020 the S&P 500 will be trading at 18x our 2021 EPS estimate and 20x buy-side expectations,” and 26x its downside case scenario. Those unfamiliar with earnings multiples should note that levels of 18x to 22x represent bull market extremes pricing perfection and a 26x multiple would be a hereunto unseen level recorded.
Kostin says, “the risk of an economic, earnings, trade, or political hiccup to normalization means near-term returns are skewed to the downside, or neutral at best.”
The Risks
- Equity market technicals suggest lofty levels are not sustainable for long
The five largest stocks in the S&P 500 now account for 20% of its market capitalization, exceeding the 18% concentration level reached during the dot-com bubble. The dispersion in returns and the consequent rapid decline in market breadth is clear.
A growing dispersion in returns and narrowing breadth among stocks typically signals future periods of below-average market returns and eventually a reversal of upward market momentum. Validation from the past include the tech bubble, as well as periods ahead of the recessions in 1990 and 2008.
- Cautious Rehiring
Companies may rehire fewer employees or at a slower pace than investors currently expect. In a stagnant economic environment, many firms are borrowing money to finance ongoing operations. Even with low interest rates, increasing corporate leverage will ultimately restrain the pace of recovery. Furthermore, companies are accelerating the trends of digitization, automation, and direct-to-consumer business – moves that will hurt sections of the workforce that need jobs, the most.
- Medical developments
There are several wildcards here that could skew economic outcome in either direction. While a successful antiviral therapeutic or a vaccine could potentially save the day, a second wave of infections would be a disappointing and disrupting development.This is especially pertinent as, outside of NY, the case load for the rest of the US has remained relatively steady and stands to turn for the worse.
- Trade tension between the US and China and the move towards De-globalization
The tariff war between the US and China is rapidly escalating with China’s regulatory legislation over Hong Kong adding fuel. Based on exchanges between politicians on both sides, the situation seems likely to get worse on the margin. Greater geopolitical instability is typically associated with lower valuations.
5. The US Presidential Election
Perhaps the most significant risk and source of uncertainty is the US election, just five months away. Prediction markets currently assign a 78% probability the Democrats control the House of Representatives, a 51% likelihood of occupying the White House, and a 48% probability of controlling the Senate. The tax reform law passed in late 2017 lowered the median effective corporate tax rate (federal plus state) to 19% from 27%. If the tax law is reversed, it would translate into meaningful reduction to any forward EPS forecast.
Conclusion
The overwhelming facts on the ground make the conjecture, to “V” or not to “V”, a rhetorical one, in the context of current equity market valuation. The market, at this point, has priced in a perfect return to trend growth for the US, that will make us all believe this was all a bad dream and never to look back at it.
Nonetheless, the seemingly endless power of the Federal Reserve matched only by its resolve, and with a compliant Congress and Administration in tow, is never to be underestimated. Both have influenced the markets to the point of reasoning any and all wins.
The end of every financial cycle of a credit fueled global economy is inevitably marked by a flush-out of bad actors, as banks, in recognizing the downturn cease to fuel the largesse. Short of the Fed stepping in to directly support US equity markets, the latter will eventually reflect the state of economic unwind, as they always have in the past.
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