G. Kevin Spellman, David O. Nicholas Director of Investment Management, has authored this comprehensive analysis.
The Market’s Hopeful Thinking
At about 2,900, the S&P 500 is only 15% off its all-time high and down just 10% for the year, but the starting points were arguably lofty levels. At its low, the market fell 35% from its intraday peak of 3,394, which is slightly more than the median bear market of 33% during the last seven recessions. The current rally implies all is now fine and well, coronavirus is just a blip, and the economy will be off to the races sometime soon. This may be hopeful thinking.
The Government to The Rescue
Liquidity saves the day. U.S. fiscal stimulus is about $2.5 trillion (more than 10% of GDP) and may be rising, which dwarfs the package (TARP was $831 billion) during the Great Financial Crisis (GFC). The Federal Reserve may double its balance sheet to $8-10 trillion from $4 trillion, and it broke new ground buying fallen-angel, risky, high-yield bonds, supporting the municipal bond market, and by lending to mainstream firms (with the Treasury picking up the losses). The speed of these actions was incredible, which explains the quick rebound in stocks. The market appears to be cheering every bit of good news on new coronavirus cases plateauing and the states’ reopening plans; prices seem to imply a V-shaped or skinny U-shaped recovery.
Will the Economy Get to a Quick Start?
Coronavirus may have shut down 29% of the economy and at least 30 million have lost their jobs in the last six weeks, or more than the number of jobs created since the GFC. Typically, Fed liquidity/rate cuts during a recession encourage firms to borrow, and this stimulates growth and rehiring. Government spending also gets people back to work. Today, borrowing and government spending is just offsetting short-falls and keeping firms afloat. Normally, the Fed/government is like the good car that jumpstarts the dead car (recessionary economy) to get it back on the road (to economic recovery). Today, the battery is so dead that the big jolt of electricity appears to only be providing enough juice to run the radio. Organizations continue to lay people off in droves, but maybe some will be hired back. They are at least required to do so if they borrowed from the U.S. Paycheck Protection Program (PPP). The current fiscal stimulus will get firms through a few months. Will the government be willing to fund firms even longer as debt mounts if the economic recovery moves in waves of starts/stops?
Perhaps only 2% of the population has had coronavirus and it takes 50% to get to herd immunity if each person just gives it to two others. This may mean that this car needs a lot of juice. On April 29, Fed Chairman Powell said, “It may well be the case that the economy will need more support from all of us if the recovery is to be a robust one.” However, to get this car running on its own, one probably needs to change the moods of individuals and businesses, which means we need good news on testing, tracking, treatment, prevention, and vaccines. Testing is getting better, we had some positive news on treatment with Gilead’s remdesivir and more positive news could be coming as trial results are released, and social distancing prevention seems to be working as new cases are plateauing. Whether people allow themselves to be tracked is a question, and a vaccine is still a long way off. A big risk to the economy and markets is coronavirus wave 2.0 as states open up.
Distorted Asset Prices
The Fed is distorting asset prices with its liquidity injection into the economy.
For instance, on April 30 high-yield/junk bonds only yielded 8%+. In the GFC, default rates rose to the mid-teens, and assuming only a 25% recovery rate, this means you could lose money investing in average high-yield risky bonds this year. The Fed assumes 10% overall losses, picked up by the Treasury, on its lending. Losses will surely be higher in junk bonds than the Fed’s average loan. Starting at 8% yield for junk bonds, this means the Fed is anticipating at least 18% default-related losses for an overall loss of -10%. Are you willing to invest in this asset?
Before the Fed provided liquidity, average yields on high-yield bonds were skyrocketing and rose to 11%. If yields are now too low, investors have to move up the risk spectrum to earn decent returns. Carnival recently issued 11.5% bonds, down from 12.5% expected due to high demand, and down from 15% from what hedge funds and others had offered. The Fed indirectly saved the company a lot of interest expense.
Since 1997, stocks tended to bottom with trailing 12-month earnings (TTM), not before, and it took ten months to 50 months for earnings to rise beyond prior peaks. Firm market value tended to bottom modestly ahead of EBITDAR, and it took two to 11 quarters to get back to a new high. Because of various behavioral biases, investors typically extrapolate recent trends and don’t forecast turning points too well, at least not too far ahead. Price action’s lead to profit changes varies over time: in the 1980s the market often moved opposite of profits, in the 1950s and 1960s the market rallied ahead, and in the 2000s it has been closer to coincident.
However, the market’s lead today is substantial. 1Q 2020 is worse than 1Q 2019, 2Q 2020 will be drastically worse than 2Q 2019, and perhaps, or hopefully, by 3Q and 4Q we will be slowly getting back to normal but still much worse than 2019.
The Fed is a buyer, and it is huge. Plus, it buys counter-cyclical. Right now, the Fed is buying more bonds than are being issued and the money it is spending must go somewhere. Cash is rising, but so is the stock market. Normally we can rely on history (e.g., the relationship between profits and the stock market) as at least a partial guide. Mark Twain said, “History doesn’t repeat itself but often rhymes.” However, history is not even rhyming today and maybe it shouldn’t. Coronavirus, and the Fed’s and central government’s very substantial and quick reactions, are unprecedented.
Is the Market More Than Fully Valued?
Even if earnings and EBITDAR recover to their prior peaks and even if we suggest the market was not overvalued at that level (before the virus hit, the Shiller cyclically adjusted P/E was essentially at its highest level versus the 10-year Treasury bond since 1881, and now it is where it has never been before), would the rebound in the S&P 500 back to its prior high be reasonable? Probably not.
Lower growth and higher risk decrease valuation. Many are borrowing to get through this rough time. Higher corporate, government, and consumer debt just borrows from future consumption, so it lowers growth. Plus, it increases financial risk. Having a big buyer that does not care about asset prices – the Fed – increases the risk to investing. On April 29, Powell said, “In terms of markets, our concern is that they be working. We’re not focused on asset prices in particular.” Furthermore, distorted asset prices misallocate capital – capital goes to the wrong risk-reward options – which ultimately wastes capital so it lowers growth and increases risk. The Fed has never tried to unwind this huge of a balance sheet before, too much money supply could drive up inflation (high unemployment and a further move to the internet economy could offset), and the Fed could become politicized since it is saving firms, states, and localities, all of which raises systematic risks. Positively, maybe firms will become more productive and risk-aware as a result of the crisis, and this will increase growth and reduce risk.
I agree with Keynes that “the market can stay irrational longer than you can stay solvent,” so while I contend that the market is probably overvalued, this is not necessarily a reason for the market to go down anytime soon. It is a reason to be skeptical of the rally, but the rally is likely Fed-induced, and fighting the Fed is normally not a good idea.