“I can’t make sense of this market” – we’ve heard that a few times during this market rip higher. For any readers who have no clue what to think, hopefully this will help.
Side Note – We don’t have a dog in this fight. We could make a compelling case either way. Winning arguments is not our objective though. Positioning portfolios is. We love our positioning currently. This note is less about that and more for informational purposes. If you want portfolio specifics, don’t hesitate to reach out.
To recap 2020 – and yes, this will be a simplified recap, but should serve its purpose:
It started off calm. Then Covid-19 happened, and calm was replaced with chaos. Markets dropped…a lot. Unemployment rose quickly. The economy halted. Bond markets froze. Then…
The Fed/Congress pressed <Up, Up, Down, Up, Down, Left, Right, Left, Right, A, B, A, B, Select, Start> for unlimited cash, dusted off some facilities with a lot of letters in their name, and even created a few more, sent out checks, a lot of them, and pledged to do whatever it takes.
Then markets started rising … a lot. This, now 40+% recovery from the lows in March, has occurred despite an ongoing pandemic, unemployment numbers that have never been seen, and riots across the country, just to name a few things currently happening that sure don’t seem bullish.
Economic activity fell off a cliff. Money printing went nuts. Look at his chart where the white line is economic activity and the red line is assets of all the Federal Reserve Banks 😲:
The economic/political backdrop seem to mix with current market prices like oil and water. Does this rise make sense? Is it here to stay? Are we off to new highs?
We can give bullish or bearish answers to those questions. You can pick your side, but we’d be careful how you act on opinions in your portfolio. Risk can pop up and slap you in the face, but a Fed-fueled market can sure make cash look silly.
Bearish – The Stock Market is Expensive
Quick Refresher: When we talk about valuations, we are referring to a multiple. Most investors are familiar with the P/E ratio. For example, if a stock trades at $50 and has earnings of $5 a share, it trades at a 10x Price to Earnings multiple.
Valuations are an indicator of future returns moving forward. High valuations lead to lower returns with higher risk and vice versa. This is important, think about this when looking at these numbers below…
According to Raymond James, the S&P 500 Index finished May trading at roughly 24x the estimated earnings per share of the market overall. That multiple is near historic highs. The S&P 500’s 2020 earnings per share consensus of $126 a share is down 22% from 2019 which represents a typical recession. Even worse, the Russell 2000 (an index of smaller companies compared to the S&P 500) consensus EPS for 2020 has stabilized at $55, down 60% from 2019.
Earnings have come down dramatically due to Covid-19 and valuations have increased to near historic highs. With unemployment near 15% and uncertainty everywhere, are valuations justified to near historic highs?
Returns can only come from one of three places: Yield, growth, and valuations changing. If you own a stock, you can make money from the dividend it pays you, the growth of earnings, or people paying a higher multiple (positive valuation change).
Debbie downer reminder, valuation change is not always positive. When investors demand higher returns on investments for the risk assumed, valuations drop creating negative returns.
The Bear’s Take
Given the uncertainty and current level of valuations, a reset in the downward direction seems reasonable and the current market run up does not. This market is expensive – beware of what is to come!
Bullish – The Stock Market is Cheap
This recent market rise is more than justified…and hold on, we are just getting started.
We’re not worried about comparing the market’s valuations relative to historic numbers, that doesn’t matter. What matters is the opportunity set investors have. In a nutshell, that opportunity consists of stocks or bonds. And what matters is the relative attractiveness of those to one another. Stocks have almost never looked more attractive; this market is cheap.
Here are two snips from Gina Martin Adams at Bloomberg illustrating this point. She refers to the equity risk premium. This is simply the earnings yield (think Price to Earnings discussed above flipped upside down) of the stock market relative to the yield on bonds. She compares the earnings yield to Treasury and corporate bond yields.
First comparing stocks to treasury bonds:
Then comparing stocks to corporate bonds:
In other words – do you want to own a stock that pays 2% in dividend yield with potential for growth in earnings and positive valuation change. Or do you want to own a bond that pays 1% in interest that cannot grow, and trades at valuations almost never seen before?
The question is not even what do you want to own, but what can you afford to own? Investors have no other place to go if they want return. Buy Stonks.
One further bullish argument simply considers what a stock fundamentally is and how it is priced.
A stock is nothing more than a claim on future cash flows. Those cash flows extend far out in time. The value of a stock today is each of those future cash flows discounted. The rate in which you discount those cash flows impacts the outcome of the calculation. High rates (your denominator) low valuations. Low rates, high valuations.
The interest rate environment we are in globally is unlike any we have seen. Rates are negative in some places and near historic lows here in the US. Point being, claims on future cash flows (stocks) value is determined by the discount rate. A low discount rate creates higher valuations. You could make the case that today’s market should trade at elevated valuations vs historic simply because of this.
The Bull’s Take
High valuations don’t scare me. Relative to the other options, stocks are still cheap. With rates near lows, fed support, and an economy that is itching to get back in gear – I’m long and strong stocks!
So What’s the Answer?
Cheap or Expensive? The simple arguments for either side should help support your narrative either way.
From our seat, we’re hopeful for higher prices, but prepared if that’s not the case. The biggest issues facing portfolio construction are the structural issues in bonds (there is just no potential for returns), the uncertainty in stock valuations (economic, political, pandemic impact, etc), and the risk of holding cash.
We’re building strategies and portfolios to manage these issues. When it comes to cheap or expensive, we don’t have the answers, but we are glad we have the tools we do to balance risk and reward.
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