Fully Recovered, but Hardly Healthy
Recently a few of the large stock indices in the U.S. have nearly recovered to pre-COVID-19 values after suffering 25-35% selloffs just a few months back. But, does the current price level of the markets accurately reflect the health of our economy? This is the question that continues to perplex investors and economists alike.
Many people try to second guess the will of the market and overlay their own personal views to derive an investment path that suits their own investment goals. The complexity of today's market is proving difficult for many investors to process, and seems to be leading many investors not properly prepared for potential risks. As an organization, we are currently positioned "Risk-On" in the U.S. stock market (meaning we own our "normal" long term allocation to U.S. stocks in our strategies). We feel this would be a good time to share some insights on what we see as potential risk triggers for the U.S. markets (things that would potentially cause us to move to a "Risk-Off" stance and reduce stock exposure for our clients.)
As a baseline, we need to acknowledge a few observations that help us understand trends currently influencing money flows in US markets.
-- The market is currently pricing in 10% unemployment. This unemployment data is public information, and current as of this morning, so investors know this data. Yet, the market is pricing stocks as if we have 100% of the profitability we saw in 2019's record breaking earnings (S&P500 is now essentially back above Jan 1, 2020 value).
-- Individual stocks within the indices are not currently valued in-line with their individual profit expectations. For example, the top 5% of stocks by size in the S&P500 are selling at unprecedented high multiples of earnings, whereas a vast majority of stocks in the S&P are only selling at slightly elevated P/E ratios.
Once we understand the circumstances creating these conditions, we have to consider what could change those circumstances to have any predictive guidance as to when the conditions driving the market prices could change.
Our view on the circumstances causing the trend is 3 core factors: 1.) Due to federal reserve policy, interest rates have been manipulated to near 0%. With no risk-free options to earn any noticeable interest on deposits or conservative investments - savers, investors, asset allocators, banks, and corporations with cash on their books ALL are forced to buy risk assets (stocks, corporate bonds, real-estate, metals, etc.) in order to make any return on their investments. In other words, policy makers have created an environment where it is nearly impossible to earn a return on any money unless you buy stocks (or other risk assets.)
2.) Retirement plan flows continue to pile into stocks through pensions and 401k plan deposits. Indexes and target date funds make up the lion's share of retirement plan assets, and these types of investments send more cash to buy the largest companies within the indexes, regardless of how expensive they become. It becomes a self-fulfilling cycle in that the larger the company is as a percentage of the index, the more money flows to buy that company stock on new investments, which makes the company even bigger than its index peers. This explains how the overall index can be valued as if nothing is different today than we had Jan 1, 2020, but the dispersion of valuations within the index itself has become extreme, with the largest companies having categorically the highest price tags, and the smaller companies having the lower price tags, completely independent of actual profitability in many cases. Another important fact regarding retirement plan flows is that a large percentage of currently unemployed Americans (service, retail, hospitality) workers, have not historically been significant contributors to retirement plans. This helps us understand how this COVID-19 induced recession has not hurt flows from retirement plans into the stock market like most recessions. This could be part of the explanation why the overall market is priced similarly today (with 10% unemployment) as it was priced earlier this year with 50-year low unemployment (around 3%).
3.) "Buy the dips" as an investment philosophy has never really hurt the millennial generation, yet. With over 30M+ young adults having entered the American workforce in the past 10 years and many contributing some percentage of their income to investing in the stock market, a prevailing strategy for this group is to invest more on the market dips and get shares of stocks "on sale". Tenured investors have long maintained this simple and mostly prudent approach to building wealth. The difference at this moment is that this large population of investors is simply not old enough to have had much money invested during a multi-year correction, so they have never endured the pain that comes from seeing years of hard earned savings lose 30-70% of its value and remain at those discounted levels for any real length of time (like 2007-2009, 1999-2002, 1986-87, 1970-74, and many other times before that.).
It seems clear that Millennials have continued to invest so long as they kept their jobs, and a vast amount of these young investors are using low cost indexes as their stock investment of choice. Because "buy the dips" does not take into account valuations (stock prices relative to the earnings the company produces each year) at all, it would explain how a vast majority of the biggest companies are selling at the most extreme price tags too.
When or what would cause the market to correct and realign stock prices with companies' actual earnings? There are a few things that we believe could cause a market correction from current levels. Of all the possible triggering events, our belief is the largest threat could come from corporate layoffs in sectors that have not yet been impacted by COVID-19 slowdowns. Between government subsidies from the CARES Act, a widespread shift to work from home, adoption of web collaboration tools, and online fulfillment of goods and services, many sectors have not had to cut many/any jobs during the pandemic. However, as the CARES Act funds and other stimulus winds down and consumers are faced with tough choices about working despite COVID-19 concerns, it is possible that many new industry groups may become adversely affected and be forced to have layoffs.
We feel that corporate employment is a major factor because of retirement plan flows we mentioned earlier. If corporate jobs are lost, that would shut off that flow of funds constantly applying upward pressure on stock prices. The things to watch the could lead to layoffs could be things like drops in the household consumption of goods and services (causing companies to sell less products), diminishing profit margins caused by the implementation of new COVID-19 safety protocols on all workplace environments, loss of staff productivity if parents of school aged children cannot return to work full-time, political policy changes that raise costs to businesses such that they feel it necessary to trim labor costs to offset, increases in short term borrowing costs that corporations are enjoying at this time with near 0% interest rates, or even the potential for a corporate liquidity crisis if corporate bond prices were to fall dramatically in a fear based market sell-off (which the Fed squashed earlier this year by promising to purchase unlimited amounts of corporate bonds to avoid a run on the bond market.)
What do the investment markets hold for long-term investors? Although we have identified some unhealthy characteristics of the current market landscape, history shows us that American capitalism has propelled decade after decade of growth in the stock market. A common phrase many tenured investors have heard is that the stock market seems to always" climb a wall of worry." There are always cracks in the foundation of a healthy economy. Occasionally there is a geopolitical disruption, a natural disaster, and even war, but the resilience of capitalism to produce profits over the long term is pretty consistent. With the steady progression of over 30 million Millennials marching toward their peak earning years (and peak consumption years) over the next 10-20 years, our view is that long term investors will continue to be rewarded by owning stocks of quality companies, despite some uncomfortable bumps in the road along the journey.
THE BOTTOM LINE: The market looks to be recovered, but all may not be what it appears. We are watching for specific things that could trigger a short-term correction and have a plan of action. Long term, investors should own stocks and try to hold on for the ride.