June 24, 2020 - As of writing this email, the stock market has almost gained back what it lost since the beginning of 2020, leaving many scratching their heads about what is driving the market and what could derail this recovery? You can find bulls and bears with equally compelling arguments on both sides, which might leave you with a sense that the valuation of the stock market is nothing more than a guessing game.
The S&P 500 index now trades at 22 times next year’s estimated profits. This level is stretched above an average of 16 times earnings, but has not yet reached the levels seen during the dot-com bubble in early 2000. However, it does read as investors being very optimistic about the ongoing reopening of the U.S. economy. The current level of the market has everything priced to perfection around a reopening without any backslide that derails the reopening, such as a possible second wave of Coronavirus infections. While most investors are not expecting the Coronavirus to miraculously go away, the question will linger as to whether we are doing enough to avoid another full-scale shutdown when the next cold and flu season comes around.
Looking under the stock market’s hood to see the engine of the market recovery, we see the Federal Reserve Bank’s actions to bolster the economy driving the steepness of the stock market recovery. First, by dropping interest rates to near zero, the Fed effectively pushes large investors, such as pensions, to seek returns in the stock market. Second, by injecting dollars into the economy, the Fed removes concerns of mass corporate bankruptcies, which gives investors the confidence to invest and stay invested. The Fed’s support for the economy is not going away, but getting the policy correct is a delicate balance. Letting the stock market get out too much in front of the economy could lead to a second bear market in 2020 if things do not go as well as expected.
It is sensible to question this stock market rally. Looking around at Main Street in any town, we can all see businesses that will shutter for good and jobs that will be lost as a result. The economy is obviously struggling. The point being that a lot of people, including journalists and industry insiders, are conflating the economy with the stock market. Whereas the U.S. economy deals with all 350 million of us, the S&P 500 only measures the 500 largest publicly traded companies. These 500 companies represent about 10% of publicly traded companies in the U.S., but it might be easier to think of them as the “1%.” Given the position these large companies occupy within the U.S. economy, they have readier access to the Fed’s liquidity programs, entered the crisis in relatively strong financial health, and can lay off a chunk of their workforce without imperiling the business. The result is a forward-looking stock market that reacts to changes in the economy rather than the current level of the economy. So, even while the job numbers are awful, any improvement is perceived as a positive in the right direction by the marketplace. The news has been one of ongoing incremental improvement since mid-April, which has lifted the stock market to its current levels.
How are we thinking about this for our client portfolios? We are cautious of current valuations in parts of the stock market, but we strongly believe in the marriage of portfolio management with long-term goals. We are keeping client portfolios more diversified than most other managers across global stocks*. We maintain an overweight to value stocks, given price-to-earnings multiples for value stocks are not as stretched as the broad market. On the bond side, we remain very conservative, maintaining virtually all fixed income in investment grade bonds with a lower chance of default or bankruptcy and keep a decent chunk in more liquid parts of the market. We don’t time the market and this year has put a big exclamation point on why not to do it. We are keeping portfolios close to their long-term allocation, taking advantage of tax-loss harvesting opportunities when they arise, and rebalancing portfolios if they get outside their risk bounds.
We understand that recent volatility in the markets has been jarring both on the downside and the upswing. It may leave you with questions pertaining to particular investments, your overall portfolio, or how it might impact your long-term plan.
We are here to answer questions, serve as a sounding board, and help in whatever way we can. Please do not hesitate to reach out to us.
*Source: BlackRock’s Advisor Insights Guide, Spring 2020.