Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
The second quarter of 2020 saw massive gains in the major U.S. stock indexes. Granted, this was a bounce off a brutal first quarter, but the major domestic stock indexes are currently expensive relative to earnings. The tech-heavy NASDAQ index has been hitting all-time highs.
Discussions of the dissonance between stock prices and the economy are everywhere.
The U.S. equity markets are betting that COVID-19 will have little or no impact on earnings growth. The S&P 500 is down about 3% YTD (through the end of Q2) and the NASDAQ 100 is up by almost 17% for the same period. These changes are on top of stock valuations that were already high at the end of 2019 (as measured by the S&P 500 P/E and the Shiller PE10). From a fundamental perspective, the market consensus is for robust earnings growth.
The real economy looks rather different than stock valuations imply. The economic impact of COVID-19 is still unfolding, as the U.S. is in the midst of the second wave of infections. Meanwhile, the unemployment rate stands at around 13% (although the Bureau of Labor Statistics has not yet provided the updated value through the end of June). The percentage of working-age adults who have jobs is the lowest it has been for more than five decades. The International Monetary Fund (IMF) is predicting the worst global recession since the Great Depression. The economic data says that we should be revising our earnings outlooks dramatically downwards, which would imply that stocks should be selling at a discount relative to their pre-COVID levels.
How can we reconcile the dissonance between economic conditions and stock valuations? I offer four theories.
Theory 1: Government will prop up the economy at all costs
The government has gone to extraordinary lengths to stimulate the economy, from direct payments to individual households, to the Paycheck Protection Program, and having the Fed buy up corporate bonds. The federal government has committed almost $2.5 trillion to stabilizing the economy during COVID-19. If we believe that the government will continue to commit massive amounts of public funds, it is possible that the near-term impacts of the pandemic will be substantially mitigated. Longer term, the associated huge increase in government debt could create economic drag, of course.
Theory 2: Stocks are more likely to provide positive real returns than anything else
This is also called the “cleanest dirty shirt” argument for investing in U.S. stocks (a comparison coined by Bill Gross back in 2012). The question is not whether U.S. stocks look expensive, but rather whether there is anything better. Every asset class is expensive. Even though the prospects for attractive real returns are questionable, what are the alternatives?
Theory 3: Day trading by socially isolated people
With the combination of social isolation and boredom, the shut down in sports gambling, and the widespread move to commission-free trading, day trading by individuals has surged dramatically. Day traders are short-term speculators, so there is no reason to expect that market trends driven by their activity will have any coupling to fundamentals.
Theory 4: Stocks increasingly represent exchange value
As wealth becomes more virtual, stocks are increasingly being purchased for their exchange value rather than fundamental value. In other words, investors may be buying stocks with similar logic to that they used to justify buying bitcoin: There is a limited supply and other people will want to exchange their dollars for these units of exchange, whether this is a bitcoin or a share of Tesla (TSLA). With a forward P/E of 385, it is hard to argue that investors are considering fundamentals when they buy TSLA and are instead purchasing it because of its scarcity and limited supply.
With the general demise of dividends, the connection between stock price and earnings is tenuous. In theory, a stockholder has a claim on a proportionate fraction of a company's future earnings. The reality, however, is that the investor has no way to actually claim those earnings. As such, stock prices can easily become decoupled from earnings and reasonable estimates of earnings growth.
Conclusions
The extreme decoupling between stock prices and the real economy is due to a combination of these four drivers. The government's massive stimulus expenditures and exceedingly low interest rates are ultimately borrowing from future consumption, however. The increase in day trading is probably a factor, but the magnitude of their impacts on market movements are debatable.
The biggest drivers are mechanisms (2) and (4). Where else are people going to put money that is obviously a better bet than firms that are and can be expected to do well in whatever emerges in the next year or so? Amazon and Microsoft are examples (disclosure: I own both of these names). The fourth mechanism, a shift towards broadly ignoring fundamentals and viewing stocks are a store of real value, albeit one with some growth potential, is the most significant. In a virtualized economy, how much real difference is there between a share of Tesla and a bitcoin?
Geoff Considine is founder of Quantext, an analytics consulting firm. Quantext is a strategic adviser to FolioInvesting, a brokerage firm specializing in offering and trading portfolios for advisors and individual investors
Read more articles by Geoff Considine
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
