The hit series “Stranger Things” on Netflix takes place in the small town of Hawkins, Indiana. This town unwittingly becomes the scene of extraordinary mystery and intrigue. The most uncomfortable and haunting periods of the drama are when the viewer is taken with the characters to the Upside Down. The Upside Down seems to be an alternate dimension – it is a dark, empty, and disturbing place. The surroundings feel familiar but are distorted in space and time. It is a world which can feel eerily like our own right now.
As we have ventured back into the world to embrace our daily lives, things are still familiar but just a bit askew. Businesses that were vacant during the lockdown, now bustle with customers, but a sense of comfort is lacking. The continued distortion of space and time the pandemic seems to bring with it continues to be palpable. For these reasons it can be hard for investors to wrap their arms around the positive stock market performance. Earnings are falling, profit margins are falling, and virus counts are rising. But the stock market continues to rise. The Upside Down indeed, a plane out of phase. While the real world has no monsters, an invisible virus and the ensuing economic uncertainty along with social unrest can be unnerving enough.
The alphabet soup of descriptions grows as people grapple with how to forecast and describe the path of the economy from here. One fund company likely provided the most accurate and certainly the most honest prognostication with the headline, “Pandemic Alphabet Soup: When V, U and L Spell “IDK”. For those of you with a weak texting game, IDK means “I Don’t Know.”
And what will be the continued path for the financial markets? Diversification always makes sense, and in an environment such as this, it is even more important. The “V” stock market recovery has been found in a few mega-cap growth stocks like Apple, Alphabet, Amazon, Microsoft and Netflix, with a more meager recovery found in the rest of the S&P stocks and everything else for that matter.
Always remember that economic data is backwards looking and the market is a forward looking mechanism. This is one reason why the financial markets may appear disconnected from the economy reality. At present, the market does appear to be looking past the wipeout of 2020 earnings and into what might be a rebound into 2021. As long as the downturn is not too long or too deep, the market can look past this decline in earnings. It has paid to be optimistic about the recovery, but significant risks still remain. Some things worry us while others not so much.
One big item pundits are talking about are the elections in November. As Biden has built a lead in the polls, we’ve seen some worrisome forecasts around what his presidency could mean for the markets, just as we saw for a Trump presidency four years ago, and an Obama presidency before that. Politics is an emotional subject. Letting emotion impact investing is not a good formula. The table below provides historical data for the S&P 500 during periods when Democrats held both the Presidency and Congress. The performance is comparable or even higher than the historical averages. While every situation is unique, in general, a change in the White House can probably be scratched off the “to worry about list.”
On the other hand, the VIX volatility index, also known as the fear gauge, is predicting greater stock market volatility in front of this presidential election than in the previous two cycles. This could mean a bumpier ride heading into the end of the year.
Another concern for investors is whether stock market valuations are already too high. The price investors are willing to pay for a stock is a complex cocktail of the level and direction of interest rates, inflation, and earnings, among other factors. One simple and commonly quoted metric to measure valuation is the price to earnings ratio (P/E ratio) with a higher number indicating stocks may be expensive. While a number of experts say that today’s P/E ratio is far too high, the chart below illustrates that the P/E ratio for the S&P 500 has shifted higher rather significantly over the last 20 years, and anyone waiting for a retreat below its long-term average to declare the index a “good value” only had a brief moment in time during the financial crisis of 2008-2009.
One reason for the move higher may be because S&P 500 sector-weightings have shifted from value-oriented companies in the materials, energy, and industrial sectors to growth-oriented companies in technology, healthcare, and communications, which on average earn higher returns on capital. See the chart below.
The reordering of the US economy to an economy around intellectual capital from physical capital has generated higher returns for those companies and they have gradually become a greater share of the market, and thus garnered a higher P/E ratio for the market as a whole. And although valuations are slightly elevated, particularly given the uncertainty around earnings, they still look attractive relative to bonds.
Last week, the largest US banks (JPMorgan, Bank of America, Wells Fargo, Citibank) reported earnings and the conference calls provided some eye-widening details. “This is not a normal recession,” JPMorgan CEO Jamie Dimon said on his call. Dimon added that the effects of the recession have been pushed down the road because of stimulus measures provided to keep the economy afloat. As those programs come to an end, it could spell trouble ahead. Citigroup CEO Michael Corbat expressed a similar sentiment on a call with analysts. “I don’t think anybody should leave any bank earnings call this quarter simply feeling like the worst is absolutely behind us and it’s a rosy path ahead,” he said. He continued: “We don’t want people leaving the call simply thinking the world is a great place and it’s a V-shaped recovery.”
JPMorgan, Citigroup, and Wells Fargo collectively set aside $28 billion in the second quarter for bad loans, according to earnings reports released Tuesday. The only time the banks have set aside more money for potential defaults was in the last three months of 2008 amid the great financial crisis, Bloomberg reported.
The big banks appear to be hunkering down for a long-haul ordeal, a stark contrast to the stock market’s behavior. When the bankers are this cautious, some investor wariness may be warranted.
Much of the country is starting to see a slowing mobility through mandated slowdowns or reversals of re-openings or in many cases people are simply slowing their activities on their own volition as the rate of infection grows. The reduction in consumer mobility does appear to be correlating to a reduction, at least for now, in consumer spending in some very big states. This coincides with the banks setting aside the greater reserves for losses as economic activity may subsequently recede as well.
The slowdown, or potential for slowdown, is coming at a time in which the economy has been surprising mightily to upside. The Citigroup Economic Surprise Index is at one of the highest levels ever as the economic data has leapt over the very low bar forecasters had set for the virus laden economy to beat. The hard part will now come as forecasters and investors move their expectations up to meet the more robust economic output, and the surprises by the data could all of a sudden be to the downside. Especially when paired with slowing mobility and slowing state openings. Something to monitor closely as investors watch rate of change as much as level of data.
To conclude, the cross currents are many and the near-term picture suggests turbulence may be near. An elevated VIX futures market, slowing mobility numbers, an economy that may be setup only to surprise to the downside, slightly overvalued and overbought stocks, all point to the possibility of a slowdown in stocks ahead. However, valuations and data look to suggest that if the virus can be contained the economy will turn the corner into next year. Banks appear to be preparing for the worst, the stock market preparing for more unprecedented stimulus from the Fed and Congress. If the economy remains in the Upside-Down world that is askew and on a plane out of phase, the mega-cap growth stocks will most likely continue their safe haven status in the world of equities. If a vaccine is around the corner as some suggest, or herd immunity takes hold, the investors will reward the unloved value stocks as everything that is familiar will again be normal and no longer unsettling. In the meantime, we are maintaining a modest underweight to stocks as the near-term outlook is quite muddy. As always feel free to touch base with any questions and please let us know if there is anything we can do to serve you in a more personal way.