A Fed-Fueled Rally
The fear of missing out has been palpable in recent days, as the S&P 500 marches towards its 200-day moving average, and the rally broadens to include small cap stocks. We have also started to see a rotation in leadership in recent days to early cycle sectors like financials, industrials and materials, as though we were on the cusp of a new economic expansion. These developments make it easy to fall victim to the idea that we will have a V-shaped recovery in the economy.
Some pundits are still convinced that the stock market, as a component of the index of leading indicators, is a discounting mechanism of economic activity. In other words, the stock market looks ahead three to six months down the road, discounting the eventual economic reality. Therefore, the rapid V-shaped recovery in the stock market portends a similar recovery in the economy.
The problem is that the Fed destroyed the discounting mechanism of the stock market long ago when it decided to use it as an instrument of monetary policy. It continues to inflate financial asset values in the hope that a trickle-down wealth effect will fuel economic growth and an inflation target that it never managed to achieve after ten years of trying. It is no coincidence that the rally we have witnessed over the past six weeks coincided with a massive increase in liquidity provided by the Fed through quantitative easing. The rally in risk assets has been a monetary event, which does not portend an upturn in economic activity or improvement in market fundamentals.
The bond market has always been smarter than the stock market, and if we were on the verge of an economic upswing, bonds would be confirming the message that some interpret stocks to be sending. Yet the yield curve is not steepening, and long-term interest rates are hovering near their March lows. The bond market suggests the economic recovery will look like a U at best and a W at worst, but a V is not in the cards.
The Economic Scenarios
The Conference Board recently published an analysis of four economic scenarios for 2020, which include a quick recovery, as well as a V-shaped, U-shaped and W-shaped recovery. The GDP contractions for each of these four scenarios range from 3.6 to 7.4%. A quick recovery seems to be off the table, as we didn't see a peak in COVID-19 cases by mid-April, which was the condition for that outlook.
A V-shaped recovery requires a peak in new cases in early May, which looks questionable now, leading to a deep contraction in Q2, led by consumption. That would be followed by a significant double-digit recovery in Q3, hence making for a V-shape economic recovery, like what we have seen in the stock market.
The U-shaped recovery, which I think is most likely, means that we see a record contraction of as much as 30% in Q2, followed by no growth in Q3, and return to growth in Q4. The recovery is slower due to social distancing practices by consumers and businesses that balance protecting health with restarting the economic engine. The interesting aspect of both the V-shaped and U-shaped recoveries is that the Conference Board sees GDP contracting at nearly the same rate for the entire year.
The worst-case scenario is a W-shaped recovery that results from a significant second wave that requires new shelter-in-place orders for Q4. That would lead to a double-dip recession. I think that the odds are good we will have a treatment by the fall that should help reduce the fear of infection, and if a vaccine is in production by year end, then that would further support the economic outlook, taking the worst case off the table. Still, this is a distinct possibility that the stock market is not discounting at all.
Consumers Drive The Economy
It is consumer spending that fuels economic growth and not the performance of the stock market. Therefore, it is critical to consider how consumers will respond to a reopening of the economy before making assertions about the type of economic recovery most likely to occur. In a recent consumer survey report from Alexander Babbage, I learned that consumers are likely to be a lot more cautious than I initially thought. Approximately one-third of consumers knew someone who had the coronavirus, which increased their concerns about catching it. The majority were taking steps to prevent infection by social distancing and avoiding crowded places.
Perhaps not surprising, consumers said they would not fly for 90 days after shelter-in-place orders were lifted. They also said they did not feel safe doing any activity where they could not control their own seating, or one that involved being touched or touching products, for 30 days after shelter-in-place orders were lifted. Visible daily cleaning and social distancing measures on an ongoing basis were very important to consumers.
These attitudes are likely to lead to a very gradual return to normal consumer spending patterns over the coming six-month period, provided there is not a second wave of infections in the fall that requires new shelter-in-place orders. Even when activities do return to normal, most businesses will be operating at much lower rates of capacity, regardless of demand. That leads me to believe that we are likely to see contractions in Q2 and Q3 of this year, with a resumption in growth in Q4. This U-shaped recovery will lead to a 6-7% contraction in the economy for 2020.
Market Fundamentals
After the bear-market rally we have had to date, the S&P 500 is now more expensive today than it was at the beginning of the year. The index is down just 10% year-to-date, when S&P 500 earnings are likely to be down 20-30% in 2020 from the $163 earned in 2019. I thought it was insane in January to pay 20 times trailing earnings of $163. Assuming earnings decline 25% to approximately $123 in 2020, an investor is paying nearly 24 times for this year's earnings. That's absurd, especially when we have no idea what earnings will be in 2021.
The bulls are arguing that we should look past 2020 when we are valuing the market, because earnings will recover in 2021. They are not considering that growth will be slower, borrowing costs will be higher, expenses in the new normal will increase and margins will be compressed. The most influential investor in our markets the past several years will also be sidelined, as most companies have ceased share buybacks indefinitely. Given the multitude of risks we face and headwinds we must contend with, I don't think the S&P 500 deserves the multiple it had at the beginning of the year. If earnings decline 25%, and we discount the S&P 500 by 25% from its value at the beginning of the year, we arrive at 2,420. This valuation doesn't take into consideration any of the risks or headwinds I have mentioned. I think the S&P 500 will bottom at lower levels this summer.
Sell In May And Go Away
This rally has run into significant overhead resistance with multiple technical levels converging around the 200-day moving average at approximately 3,005. First-quarter earnings are showing glimpses of the complete collapse in profits we will see in the second quarter. The fact that guidance is being withdrawn across the board will keep investors and analysts guessing as to what the third quarter will look like, and the economic reports in coming months will be horrid.
I don't think investors will be able to hold their nose and keep buying stocks at these levels in hopes that that fundamentals catch up with these valuations by the end of the year. They will start selling to take profits from this record run, as I have done lately, and look to renter their favorite name at lower levels. Additionally, I have been incrementally adding to my hedges as I peel off gains from stocks purchased in March.
The old adage, "sell in May and go away" has never been more perfectly timed than it is today.
