Last week in emorningcoffee.com, I wrote an article setting forth some of the reasons that supported the recovery of the S&P 500 from its pandemic-driven lows in March, which you can find here. This bull case has gotten progressively easier to support as the global equity markets have continued to march upwards since their low close on March 23rd (2,237.4), having reached their 2019 closing level (3,230.8) earlier this week (on June 8th, 3,232.4 close). In fact, the S&P 500 is only around 4% from its all-time high achieved on February 19th (3,386.15). I will admit upfront that I am struggling to digest the incredibly rapid recovery in the stock market, simply because it has occurred whilst the U.S. economy remains mired in the deepest economic downturn since the Great Depression of the 1930s. Even so, the reality is that - at least so far - the market’s performance is supporting the bull case, and the bears are being swept aside. However, even though the bears might have been wrong so far, they have equally valid arguments that this sharp recovery has been “too much, too fast.” This article presents some of these reasons. One has to ask: how is it possible that the stock market has recovered so quickly with the backdrop of companies facing significant earnings declines, countries having to emerge from partial hibernation to rebuild their economies, and the ongoing reality of a pandemic that has no definitive “end date” in sight? These risks, which should be ingrained in the equity markets, are genuine, and the outlook is anything but certain. This article contains the reasons that I believe that the market has come too far, too quickly, and why we could be in store for a harsh dose of reality sooner rather than later.
Returns are abnormally high
In spite of the S&P 500 losing 14% in 4Q2018, the market “found its legs” – largely thanks to the Federal Reserve moving to an accommodative policy - and surged 28.9% in 2019 (excluding dividends), its best return in six years.
To put 2019 into perspective, the table to the left illustrates the returns on the S&P 500 over various periods. Simple mathematics suggests that generally over time, returns will drift towards the mean, which is depicted in the right-most column.
I also looked at the annual returns of the S&P 500 every year since 1980, to see how the S&P 500 performed in the year following the year in which the annual return (including dividends) was in excess of 20%. In 13 out of 15 cases, returns the following year declined; only in one case did the market gain (and in the final case the market was flat). In four cases involving years with a 20%+ gain, the S&P 500 not only declined but was negative the following year. As of the beginning of this week as I am writing this, the S&P 500 is about flat on the year. The S&P 500 has surged 44% in only 11 weeks, from its lows on March 23rd. The fact that 2019 was so exceptional should make investors very uncomfortable with a market that could potentially sail through the pandemic and related economic effects in 2020 as if CV19 never happened.
Valuations
The strong performance of the S&P 500 has to be put in the context of valuations, measured either by the traditional price/earnings (PE) ratio or the cyclically adjusted price-earnings ratio (CAPE or Schiller PE). The latter measure, using inflation-adjusted 10-year earnings, is often used to smooth cyclical earnings so as to better determine a long-term earnings stream. You can find out more about the CAPE ratio that was developed by esteemed Yale professor Robert Shiller here.
As of June 1st, the PE ratio for the S&P 500 was 22.3x, and the CAPE ratio was 29.2x. At the end of 2019, the same ratios were 22.8x and 30.3x, respectively, so in spite of the challenges introduced by the pandemic, the valuations remain intact. Moreover, recall that investors were having concerns as 2019 progressed with increasing stock prices but declining earnings growth, a topic I’ll cover more later.
To put today’s levels even more in context, the table to the left contains the averages for the traditional PE ratio and the CAPE ratio over longer periods of time. As you can see from studying the table, the current CAPE ratio of 29.2x is higher now than it has been for any period in the table above. The traditional PE ratio is higher than the average for the last 10 years and for the last 40 years and beyond. It is lower though for the 20 year and 30 year periods, mainly because the Great Recession period was overly influential during these periods. As you might recall, the post-Great Recession period was characterised by unusually high PE ratios as the U.S. was starting to recover from the deep recession, and stock prices were increasing ahead of the recovery in earnings (not dissimilar to what we are currently experiencing).
Below is a graph that shows the Shiller PE since the late 1960s, with recessionary periods marked.
The 1970s and early 1980s were unusual in that the U.S. economy went through a period including an oil supply shock that led to high inflation, followed by increasingly tight monetary policy as the Federal Reserve sought to bring inflation back under control in the late 1970s/early 1980s. The U.S. economy has not suffered from inflation since then.
I wanted to look more closely at valuations following cycles when inflation was tamed, so I selected five periods: three recessions (90-91, 01-02 and 07-09), the “Black Monday crash in 1987, and the current pandemic-caused recession. The table below includes these five periods, and for each provides the date, level of the S&P 500, and the CAPE ratio at i) the pre-crash S&P 500 low (i.e. normally towards the end of the prior sell-off / recession), ii) the pre-crash S&P 500 peak experienced prior to the downturn, and iii) the market low following the beginning of the recession / event.
For example, you can see in this table that the market went up 399% between Nov 1990 (occurred during the 1990 recession) and Sept 2000, whilst the CAPE ratio increased from 15.2x to 41.9x. As you recall, this was a solid economic decade for the U.S. and later in the decade, the run up to the 2001 dot.com bust. The market fell 46% during the technology / dot.com crash (including 9/11 also), whilst the CAPE fell to 27x, still high but reflecting - as you can see in most cases - the recovery of stock prices ahead of earnings (which exaggerated the CAPE temporarily until earnings caught up). (Note that this is monthly date measured on the first day of each month, except for the “pandemic recession” which - for S&P 500 levels – is daily.)
The point here is that aside from the dot.com bust when share prices fell dramatically and then recovered ahead of earnings, the CAPE ratio has fallen in every other case to the mid-to-low teens area during the post-crash low, very different from the CAPE ratio during the recession we are currently experiencing. Even on its worst day on March 23rd, the PE ratio and the CAPE ratio (estimated earnings for each) never breached 16x and 21x, respectively, nowhere near the lows in terms of valuations reached in past downturns. This suggests that the stock market is overvalued, at least based on traditional price-earnings metrics. Let me finish this section with a comment on forward PE ratios, perhaps a more appropriate measure given the fact that investors look and price stocks forward, not backwards. Refinitiv has the current forward PE ratio, based on S&P 500 earnings for 2Q2020 to 1Q2021 at 24.3x, whilst Yardeni Research has the forward PE ratio at 22.5x. Even though they are forward looking, both are significantly higher than even the trailing PE ratios over the last 10 years.
Outlook for Earnings Corporate earnings growth of the S&P 500 companies was negative for all of 2015 and most of 2016, then grew strongly in 2017 and most of 2018. However, earnings growth started to slow in 4Q2018, and actually was negative in the third quarter of 2019, rising only modestly in the fourth quarter. The graph below depicts earnings growth since 2015.
Against the backdrop of declining earnings since 4Q2018, the stock market was rocketing to new highs throughout 2019, although the slowing of earnings was increasingly bothering many investors who thought the market was getting ahead of itself. As we moved into 2020, the S&P 500 continued to march forward, nearly without pause, even as earnings growth continued to slow (pre-pandemic). This cannot be said without mentioning the shift to a more accommodative policy by the Federal Reserve in early 2019, as it began a series of interest rate reductions to (again) spur the U.S. economy.
It is hard to say how 1Q2020 would have ended without the pandemic bringing the economy, and the earnings of most companies, to a screeching halt. Still, it is important to remember that sentiment towards a correction was building throughout the latter half of 2019 and into early 2020 even before CV19 appeared.
So, what does this mean for earnings growth in the future? The table below contains earnings growth projections for the S&P 500 for the coming quarters and for years 2021 and 2022 from reputable research firms Yardeni Research and Refinitive.
As the table indicates, 2Q2020 earnings will be sharply lower, as this quarter will bear the brunt of the economic shutdown. Earnings growth will be significantly negative for 2020, but earnings are expected to resume their growing in 2021, although not reaching 2019 levels again until 2022. Of course, the ability to project earnings is difficult in this environment. These earnings also assume optimistically that CV19 will wind down sooner rather than later with no second wave, and no further disruption to the economy. In my opinion, the market is pricing in a best case scenario, so if either the economy does not continue to reopen as expected or there is a resurgence or second wave of CV19, the market will lose its support and is at risk of decreasing again.
Economy Even though the recession in the U.S. and most other countries affected by CV19 was “manufactured” by governments to combat the virus, economies cannot simply be “switched back on” and pick up where they left off. The U.S. - and for that matter the global economy - is in its worst shape since the Great Depression during the 1930s. Assuming there is no second wave of CV19, the OECD projects that GDP will decline 7.3% in the U.S. in 2020, 6% in Japan, 9.1% in the Eurozone and 11.5% in the U.K. Over 40 million Americans have filed for unemployment for the first time, and even though the unemployment rate declined to 13.3% in May, it remains the highest unemployment rate in the U.S. since 1940. Even during the aftermath of the Great Recession, unemployment peaked at only 10.0% in October 2009.
In addition, many think that the economy was increasingly fragile prior to the pandemic. The on-cycle fiscal stimulus via the $1.5 trillion Trump tax reform act signed into law in late 2017 provided a boost to economic activity during the time the legislation was being formulated and debated and - following its approval in December of 2017 - for much of the following year. Then, the Federal Reserve came to the rescue of the slowing U.S. economy in late 2018 by reversing its stance on monetary policy but signalling - and following through on - a series of rate cuts in the first three quarters of 2019. In the autumn of 2019, the Federal Reserve’s balance sheet began to grow again, providing more stimulus to an economy that was experiencing slower and slower growth even with these boosters. It seemed that the government and central bank were both working to prolong the inevitable, dragging asset prices (including the stock market) up as a result. This version of a growing U.S. economy, largely addicted by this time to stimulus, was also in a way “manufactured”. This is the reality before cutting a layer deeper, as there is also much discussion around other facets of the U.S. economy throughout the post-Great Recession growth period, including things like very weak growth in productivity, weak wage growth, low quality of jobs being added to the economy, growing wealth inequality, and so on.
In response to the government-induced recession starting in February 2020 to curtail the spread of CV19, central banks and governments released unprecedented amounts of stimulus to help people and businesses survive during the lock-down. Fortunately, these stimulus measures worked as far as softening the economic blow. Still yet, the global economy is in a very fragile state no matter how you measure it - unemployment, GDP, or any other economic metric you choose to compare this contraction to other recessions. Stock market bulls suggest that once the pandemic passes, the economy will pick right back up where it left off. I do not believe this for many reasons, one of which is that there will be fundamental changes in the way we do business, and another being the harsh reality that some businesses will completely disappear. In true American spirit of course, new businesses will be born out of ashes, but it will take some time. In addition, the stark reality is that, according to my calculations, the U.S. will lose circa $1 trillion in GDP in 2020 and 2021, compared to its expected growth pre-pandemic, and this will never be recovered – it’s gone forever. The harsh reality of this economic backdrop in which we currently find ourselves makes it particularly hard for me to believe in the current rally.
The post-pandemic world
It Is certain that the post-pandemic world will look different. Some of the changes we are being forced to adapt to are fleeting, but others will become ingrained and for the long term. For example, whilst personal travel will resume, it is difficult to dispute that business travel will be curtailed for years to come as companies realise that the cost of travel is often not worth it when the same objectives can be achieved through videoconferencing. What will this mean for the most profitable segment of air travel – business class – and for upper tier hotels? People will also work more from home, meaning some workers might work permanently from home from now on, a trend already underway prior to the pandemic. Others might work some at home and some at an office, but the likelihood is that the need for office space will decline. This, in turn, will have collateral affects on the commercial real estate business and related services. What about restaurants, sporting events, concerts, and so on which depend on density of people? Until a vaccine is developed and administered, or until there widespread immunity, all of these sorts of activities will be a shadow of their former selves.
Another mega trend developing is growing nationalisation, especially visible in discussions regarding the relocation of supply chains on shore (or at least closer to home). Many countries, of which the U.S. has been the most vocal, will encourage businesses to bring their international manufacturing back home so that they are in control of their supply chains. Of course, many foreign companies with manufacturing in the U.S. will do exactly the same. As this occurs, the cost benefits of comparative advantage will diminish, and costs – and likely prices – will rise for the global economy, meaning all countries will be losers in this respect. Indeed, there are profound changes that will roll out of this pandemic no matter when and how it ends, and the net effect will not be positive for businesses overall.
The stage of the pandemic
As I wrote about last week in the case in favour of the stock market increase, the Spanish flu lasted more than two years, from spring/summer of 1918 to spring 1920. There were four waves of the infection during a two year period, each less severe than the past. It was estimated that one-third of the world’s population got the Spanish flu in the first year. An estimated 50 million people (2.7% of the population) died. Eventually, the virus ended because of herd immunity, not a vaccine or treatment. The idea that there will be a vaccine for CV19 in the near term is far-fetched, although I – like everyone else – would like to believe it. I hear various market pundits say that a vaccine will be in production by 3Q2020 or 4Q2020 latest, and this is clearly baked into current valuations. However, who can really say at this point?
In the meantime, the question that governments around the world are grappling with is what number of lives lost is “acceptable” as a trade-off to getting their economies back to running at pre-pandemic levels, and as soon as possible? It’s not an easy decision, and although the jury is out, I suspect that the re-openings of economies will not go as quickly or smoothly as we would all like. There was discussion at one point about subsequent waves, as occurred with Spanish flu, but this discussion has been largely swept under the rug for now. Still, it is a genuine risk as people mingle more and more. Also, as the summer ends and autumn begins, the conditions for the spread of the virus improve again. There is also no certainty that the virus might not mutate anyhow to circumvent treatments that are developed.
The point is that an overly optimistic set of assumptions regarding both the demise of CV19 and the economic recovery seem wildly optimistic but are being fully reflected in current stock prices.
Other
There is a myriad of other discussions about drivers of this market, ranging from FOMO ("fear of missing out"), to excessive cash on the side lines with no feasible alternatives aside from equities, to the sudden appearance of millennial day traders. All of these reasons are retail-related, although one might imagine a scenario where professional asset managers get sucked into the same phenomenon as indices outperform their active management returns, eventually coaxing them into over-valued stocks because of an overly caviller attitude towards risk.
Conclusion
I presented the arguments that favour the sharp stock market recovery in an article on emorningcoffee.com last week, and this paper is the corollary, or the bear case. If you are wondering about my own conviction, I am afraid I find myself more firmly in the latter camp, probably because I have lived through several cases over the years where intrinsic value of stocks became disconnected with underlying earnings potential, generally leading to a correction and a recession. Having said this, I am not one to flock to cash, gold or US Treasuries, because I know that although stocks are much more volatile over time and can be subject to bubbles, they have delivered superior risk-adjusted returns over long periods of time if they are held. I have enough humility to say that I will most certainly be better prepared for unexpected downturns like this one in the future, mentally, emotionally and from the perspective of having sufficient liquidity on hand to last through prolonged downturns or to take advantage of an oversold market. You're never too old to learn!