Markets have shrugged off a torrent of horrific economic news. They have powered far above the post-pandemic crash lows of March. The fastest bear market ever, down 34% in weeks, has led to a similarly startling snapback. From the March 23rd lows, we have seen blistering gains in the Nasdaq (36.7%), the S&P500 (32.8%), and the Dow Industrials (32.2%).1
This move towards all-time highs has the old guard questioning the rally, especially equity valuations:
-David Tepper call this the “most overvalued stock market” outside of the 1999 bubble.
-Stanley Druckenmiller is “bracing for a bear market.”
-Leon Cooperman suggested stocks could fall as much as 22%.
-Mark Cuban said “Stocks are overvalued and the risk-reward isn’t there till we see a cohesive plan for testing from the government.”
-Howard Marks cautioned “Those of us in markets believe that stocks and bonds are selling at prices they wouldn’t sell at if the Fed were not the dominant force.”
Are anecdotes from famous investors a fair way to measure valuations? I appreciate the insight of these billionaires, but allow me to suggest other ways to contextualize equity valuations:
Recent history: Since it is that 30%+ rally off the lows that seems to have startled so many, let’s use that as our leaping off point. Frame the present move in terms of the S&P 500 Index falling 34% to its March 23rd lows. That month was one of the 20 worst in market history, and the fastest bear market ever. Deeply oversold, the market rubber band got stretched too far in one direction. Hence, the snapback rally. Once its overdone to the upside, argues the technical types, it will swing the other way. Eventually, equilibrium is achieved.
It is inappropriate to focus on the strength of this rally while ignoring the sheer speed and force of the collapse. Looking at one without the other is the investor’s version of denominator blindness.
Markets are forward-looking: Equity markets do a great job making probabilistic assessments of likely outcomes. Regardless of your views of the efficient market hypothesis, you have to admit that markets sniff out shifts in economic data and corporate profits or revenues long before the official news is released.
Meanwhile, economic data looks backwards. The weekly first time initial jobless claims are an assembly of state data, which is already known days earlier. Monthly non-farm payroll can be deduced via other data sources a week or two prior to the official BLS release. And GDP is so old as to be months behind what already has occurred.
The sell-off in February was arguably in anticipation of unprecedented (!) layoffs and great Depression level unemployment. What underlies the market recovery over the past 6 weeks is a similar forward look towards economic data that is less awful, the end the lock down/ re-opening of America, and a medical solution to the pandemic challenge.
Earnings at Zero: How can we put a value on stocks when, through no fault of the companies themselves, earnings drop to near nothing? When the year began, we were looking at 2020 calendar year earnings consensus around $165-175 on the S&P 500 Index. The second quarter was going to be about $42; it is now more or less zero.
The best comparison to the States’ “Shelter-in-place” orders was the shut-down of civilian manufacturing during WWII. It appears that investors today are looking past the valley of no earnings, in anticipation of prior expectations of economic expansion. This is similar to how U.S. markets acted in the face of an existential crisis from 1939-44.
Whether markets are too far ahead of themselves or not will be determined by events: How quickly a treatment and/or vaccine for Covid-19 is discovered; how successfully the re-opening process goes. Lastly, how soon the consumers – aka the demand side of the economy – becomes comfortable with going out, spending money, and generally returning to their prior consumptive ways.
Anticipating the Next Downturn: At some point in the future, the markets may get an early read on the next problem. Perhaps there are issues with the efforts to re-open the states; maybe there is a big spike in infections and deaths. Perhaps we make little progress on treatments or a vaccine.
Stocks fell before most people had any idea how serious this pandemic was going to be; they are recovering because the probabilities of getting through this sooner rather than later is higher than most believe.
But this does not mean there is only one path forward – there are many possibilities. If we experience a setback in any of these issues above, be they medical, economic, or even consumer psychology, you should expect to see that show up first in equity markets, as a move downwards.
What if the Bull Market Didn’t Actually End? I know this sounds like a reach, but hear me out: What if the pandemic – an externality separate from the business cycle – did not cause the bull to end? What if this is only a temporary pause, an artificial reduction in earnings that reverses as circumstances normalize? It could be more akin to a natural disaster (Volcano or meteor strike) than a cyclical economic contraction – then what?
I have defined secular bull markets as broad economic expansions, rising corporate earnings and revenues; stocks break out of their prior bear market trading ranges to a new high; sentiment improves, with investors willing to pay more for each dollar of earnings. Typically, these phases last 10 years or longer.
The idea that the pandemic paused the bull and it can resume is not hindsight bias: I discussed this concept repeatedly (see this, this, this and this). It’s a stronger probability than many perplexed investors believe.
We have never experienced anything quite like this pandemic / shelter-in-place induced economic freeze and earnings collapse. It is one-part Great 1906 San Francisco Earthquake, one-part September 11th terror attacks, and one-part Pearl Harbor bombing.
Asking if stocks are too expensive right here mid pandemic is the wrong way to think about this. A better question: Whether the post-recovery profit environment will justify currently lofty but temporary stock valuations. How you answer that earnings question will determine your investing posture.
1. The Nasdaq 100 Index is now up 9% year-to-date, the S&P500 Index is off 8%, and Dow is still down double digits.
End of the Secular Bull? Not So Fast (April 1, 2020)