I started an article about the remarkable equity market recovery several weeks ago and am just now finishing it, unfortunately a bit late since the S&P 500 has continued its one-way march upwards. I am going to present both the case for and the case against this recovery, with the former – this article – obviously looking much more “correct” at the moment. I will cover this topic in two articles, with the second one to follow next week taking the counter-view that the recovery has been “too much, too fast.” As difficult as it might seem to many that rely on company fundamentals to justify how we are back at these levels given the difficult economic backdrop, there are seven reasons that I can think of which suggest that this sharp recovery is entirely justified. For context, here’s the journey of the S&P 500 this year (from Yahoo Finance).
1. Peak-to-trough-to-recovery is not abnormal: Normally following a stock market downturn, the time it takes for the stock market to achieve its pre-sell off high after reaching its trough takes months if not years. In addition, even though the stock market is a leading indicator, it is normally more closely correlated from a trajectory and timing perspective with the economic recovery. This fact alone makes the current recovery seem all the more bizarre in that we are right in the middle of the worst economic decline since the Great Depression of the 1930s, yet the stock market is rallying. In fact, you might recall what Warren Buffet said at the recent Berkshire Hathaway (virtual) annual shareholders meeting. Mr Buffet reminded the attendees that it took the DJIA 25 years to recover from its plunge in 1929, during the midst of the Great Depression, to reach the same level again (in 1954). The table below provides a look at the last seven downturns using S&P 500 data, with the periods mostly representing recessions in the U.S.
To explain the table, let me walk you through the first line, the 1968-1972 period. The S&P 500 went from a peak of 108.4 in November 1968 to a trough of 72.3 in May 1970 (77 weeks) and did not then reach its November 1968 high again until April 1972, 98 weeks from the trough. The ratio of time for the market to go from peak-to-trough to trough-to-former peak was 1.3x in this case.
The average time it has taken for the S&P 500 to go from its highest level to its trough is 63 weeks, whilst the average time it has taken for the market to then recover and achieve its former high is 160 weeks. Therefore, the average recovery time ratio has been 2.8x.
The final chapter is not written on the current recovery. However, the S&P 500 took only five weeks to fall from its peak to its trough between February and March, and therefore a fast recovery – especially in light of the fact that this recession has been “self-manufactured” by governments to combat the pandemic – does not appear out-of-line given the history of such recoveries.
2. The yield curve is steepening slowly, signalling recovery – Both the absolute level of yields and the shape of the yield curve are usually forward indicators of the future of an economy. As concerns escalate over a possible pending recession, investors shift out of risk assets and into US Treasuries (“USTs”) as a safe haven trade, as well as in anticipation of lower rates from central banks to stimulate economic growth during a recession. Similarly, a steepening yield curve reflects optimism regarding the future, as investors sell USTs (pushing up their yields) and invest in riskier assets like equities. I looked back at every recession since the 1970s in the U.S., and throughout the recessionary period, the yield curve measured as the difference between the 2- and 10-year UST was steepening in anticipation of the recovery by between 75bps and 175bps from its lowest point. For reference, the 2-10 year UST yield differential was 254bps in mid-2009, when the U.S. began its recovery from the Great Recession. The average yield differential throughout this record-long expansionary period was 145bps. The current 2-10 year spread is 63bps, having increased from a low of only 11bps on February 27th. The yield curve is steepening in anticipation of an economic recovery that is signalling also that there should be earnings growth in future quarters, a positive for equity investors.
Before leaving this topic, it is important to remember that the yield curve might be significantly steeper today were it not for the massive amount of monetary stimulus in the form of quantitative easing being undertaken by the Federal Reserve. This activity most certainly supresses yields because the Federal Reserve is a buyer of USTs in the secondary market, adding pressure to prices and conversely flooring yields. This is most likely causing the steepness of the yield curve to be understated. In spite of this, the increasing steepness of the yield curve is signalling strongly that an economic recovery is in the cards.
3. Unprecedented monetary and fiscal stimulus has been unleashed – The pandemic in the U.S. has been greeted with stimulus measures from the government and the Federal Reserve estimated to be more than $6 trillion to combat the economic effects of CV19 on the U.S. economy. The fiscal stimulus has amounted to nearly $4 trillion (CARES Act plus) with more likely coming, whilst the Federal Reserve has increased its balance sheet from $4 trillion to move than $7 trillion. This record amount of stimulus has served its purpose, softening the blow of a shuttered economy for people and businesses. However, it has also fuelled the appreciation in nearly all asset classes, aside perhaps from certain segments of the real estate market. The target of stimulus this time is different than during the Great Recession, when arguably most of the stimulus was directed at stabilising the financial system and, as a result, did not find its way into the real economy. The unprecedented stimulus this time is going straight to consumers and businesses to fuel the recovery as the economy gradually reopens. Without question, it is providing a firm floor to the equity markets, as consumer spending will likely be the engine that leads the U.S. economy back to growth.
4. It’s “cheap as chips” to raise financing in the bond market – The Federal Reserve stimulus measures touched on above have obviously provided many companies with unprecedented access to the debt capital markets, both in terms of amount of debt they can raise and the cost of debt. This is different than the asset-purchase programme that was launched during the Great Recession, since the Federal Reserve has now widened the scope of its purchase mandate to include corporate bonds, not just USTs and asset-backed securities. It has even expanded its mandate to include primary and secondary purchases of fallen angels and high yield ETFs. This has both driven down credit spreads and allowed companies with otherwise “fringe” access to the debt markets to raise bond financing in large sizes and at low cost. One example is Boeing, which raised an unbelievable $25 billion in the bond market when they were teetering on requesting government assistance just to survive. Another example albeit at the other end of the spectrum is Amazon, which just raised $10 billion in the bond market with maturities ranging from 3 to 40 years. The $1 billion 3-year tranche has the lowest-ever USD corporate coupon of 0.40%. This bodes well for U.S. companies that rely on debt financing and gives many other companies an opportunity to build a liquidity reserve for the future that they might have ignored before the pandemic. Generally, this is a positive of course for equity markets, too.
5. COVID-19 will eventually run its course and a vaccine will be developed - There will be a treatment and / or vaccine for CV19 at some point, and if not, collective immunity will eventually end the pandemic. In fact, after killing an estimated 50 million people worldwide between 1918 and 1920, the Spanish flu eventually died out (although not completely) due to collective immunity, not a vaccine. However, during this period, nearly one-third of the world’s population was infected according to this article in Wikipedia. Also, there were several waves of the Spanish flu during that pandemic. Medicine has improved substantially since then, and even though many countries did not take CV19 seriously enough initially, the hope is that through advances in medicine resulting in treatment of the virus and/or development of a vaccine, and lessons from the past regarding the spread of the virus, the economy will recover quickly as people and businesses – for now – become accustomed to moving forward in spite of the pandemic. The stock market largely seems to have moved on from the pandemic, anticipating this very outcome and quickly.
6. Countries and states are reopening - This might have been more unknown a few weeks ago, but the fact is that we are now in the middle of the gradual reopening of the global economy. The speed and phases of the reopening vary by location, but generally, the countries which shut down first have been least affected and are in more advanced stages of reopening. Although many businesses and even entire industries might be profoundly changed or even disappear as the economy reopens, most are gradually easing back open with early signals that economic activity is increasing. Demand will continue to improve - this is indisputable because of the incredibly low base off of which we are coming. Since the economic shutdown was a path chosen by most governments to flatten the curve of CV19, the decision to reopen economies should progress well, even if it takes time to get back to pre-pandemic levels. In other words, it’s a move in the right direction that is likely to gain momentum, and - assuming a serious second wave is avoided - will undoubtedly improve earnings for the second half of 2020 and onward.
7. But what about earnings, which will be harshly down in 2Q? - I recently heard a presentation by distinguished professor of finance at The Wharton School Dr Jeremy Siegel. Dr Siegel made several arguments in favour of the equity market recovery, but the thesis that underlay all of his conclusions was that equity investors look forward, and he was clear in saying that he meant very far forward. He made the interesting point that since companies are valued based on discounted future cash flows, even if companies were to earn $0 the next four quarters, the effect on valuation using a discounted cash flow model would only be a reduction of around 10%. Moreover, it is also mathematically the case that future cash flows have more value when discounted back to the present because of the near-zero interest rate environment in which we find ourselves today. These arguments obviously converge, flooring most company stock valuations as shareholders look years out when projecting earnings and are using a very low discount rate to bring these back to present value. These arguments might even suggest that equities were significantly oversold at the trough in last March, making their recovery less significant than it otherwise seems.
In the second article on this topic, I will take the other side. I will look at the reasons that many investors believe that the market has come too far, too fast, and is significantly over-valued in light of the economic backdrop and damage to many businesses because of the pandemic.