The Valuation Non-Puzzle … and … Dangerous Curves Ahead
After an outstanding stock market recovery in the 2nd quarter, stocks have continued to rise over the past two months – the S&P 500 went up by 13% in July and August, meaning that stocks have now increased in value by 36%* the past five months. International stocks have also performed very well during the recovery. The rapid growth in stock prices calls attention to the differentiation between stock market performance and current economic conditions. Our recent commentaries have explained why this difference occurs – stock market valuations are singularly focused on corporate earnings -- mostly long-term corporate earnings -- while economic statistics such as GDP growth and unemployment describe current or past data that might not be completely related to corporate earnings.
A look at last quarter’s corporate earnings explains all we need to know about stock market performance over the past two months. In our July commentary, we pointed out that the consensus of earnings analysts’ forecasts was for 2nd quarter earnings to have grown by 18% relative to the 1st quarter. In actuality, that forecast was an underestimate -- 2nd quarter earnings exceeded their forecasted level by 16%.** That also means that analysts have revised their forecasts upward for future earnings for 2020 and 2021. The fact that the increase in stock values over the past two months is close to the percentage by which earnings beat their forecasted values is not purely coincidental.
Our view since the Covid crisis began has been consistent. The most likely situation is that at some point in the future, probably in 2021, the crisis and its economic impact will be largely behind us, and stock valuations will return to their pre-crisis values. We didn’t expect those valuations to come back so soon, but for the long-term investors who make up the bulk of our clients, the timing was not as important as the eventual outcome. Given this most likely view, it’s impossible for us to say the market is overvalued.
One surprise in looking at the past several months of stock price movements is there has been very little downside volatility. This has caused many investors to have a sanguine view of their equity investments. As investment advisors, we view ourselves as risk managers, not just pointing out the events that are most likely to happen, but also the events that could happen. While there are always inherent risks in investing in the stock market, the amount of potential volatility over the next few months is a bit daunting. Although we don’t think these things will happen, we can’t deny their potential to impact stock values during the remainder of 2020:
A backward slide in attempts to get control of the virus. It could be the frequently predicted 2nd wave as the weather gets cooler, failure to develop an effective vaccine, or failure of a vaccine once it’s been implemented.
A true constitutional crisis surrounding the presidential election. Both presidential candidates have been telling us that this is the most important election in history. While I personally think 1860 has something to say about that, I agree that the results will be momentous. In the past, we have pooh-poohed the impact of presidential elections on our economy and stock market -- however, more than the results of the election, the likelihood of a protracted lack of resolution in November or even December might cause erosion of investor confidence.
A continued escalation of the amount of social unrest, which eventually can lead to further disruptions in our economy.
A negative economic impact caused by the reduction in government support for unemployed workers and suffering businesses, which can lead to a sharp reduction in corporate profits and severe problems in the mortgage market.
Increased inflation triggered by the massive amount in government debt combined with a recent announcement by the Federal Reserve to not focus on inflation in determining monetary policy.
It’s important to emphasize again that we don’t believe that any of these events are likely – only that they are potential risk factors, and that the possibility of them occurring is higher than they were a year ago. There’s some evidence that we’re not alone in our concern. The VIX, a complex measure of predicted volatility in the stock market, had been steadily decreasing over the past few months, but it hit it’s low on August 17 and has been on the rise since then.
Action You Should Consider?
For most of our clients – those who are not retired or who are withdrawing very low amounts in their portfolio to fund their retirement -- we don’t believe any action is necessary. We have continually asked you to consider your comfort level with downturns, and given your long-term needs with your portfolio, you’re perfectly able to withstand a potential short-term portfolio decline. Similarly, there are many of you who are using your portfolio to fund your retirement, but have already constructed a relatively conservative allocation strategy, and we see no reason to become more conservative.
However, we do suggest that if you have a large allocation to equities, and are using your portfolio to fund your retirement, this is a great time to meet with your advisor and explore the risks of your investments.
* Source of returns is Morningstar, Inc. Past performance is not indicative of future results.
** Source: S&P Dow Jones Indices