Observers are trying to reconcile the sharp rally in the stock market even as the data show that economic activity has declined dramatically. It is natural to ask how the market can only be down a little more than 10% and the NASDAQ is now up for the year, when we’re still in the midst of a record decline in economic activity, unemployment is surging, and the outlook for the pandemic remains highly uncertain. The answer is that investors look ahead.
Simplistic explanations of the market rally include that the Fed has dumped massive amounts of liquidity into the economy and it has nowhere else to go but into security prices. On this basis, stocks are badly overvalued and on a sugar high, which will become obvious as soon as the Fed starts to withdraw some of that liquidity, causing stocks to fall apart. Or equally badly, the Fed will never be able to withdraw that liquidity without undermining the stock market, so higher inflation is inevitable. Such scary ideas are designed to promote fear, not to enlighten or understand what’s happening.
Stocks started their epic collapse on February 20 before there was any economic data indicating a downturn and the pace of decline in equities was breathtaking, with the S&P 500 falling by more than 34% by March 23, just one month later. The market has already recovered by 31% off that low, which some suggest leaves it badly overvalued. S&P 500 profits in 2020 are now expected to be around $128 per share, which implies the market is trading at almost 23 times this year’s earnings, an unambiguously high number. This is a simplistic and flawed way to look at the market. Multiples are often at highs near the trough of a bear market, just as they are often low at peaks. Theory suggests stocks should be valued this way, although there are plenty of counterexamples, partly because knowing we’re at a peak or a trough is best done with plenty of hindsight. Investors don’t have that luxury. They must make investment decisions in real time. And everyone understands perfectly well that earnings will be depressed this year because of the sharp economic downturn that is still underway. But we also recognize that the earliest stage of a recovery is already underway, as some businesses are now beginning to reopen in roughly a dozen states. Many more will reopen in the coming weeks.
Uncertainty over the pace of recovery and the path of the pandemic remains very high. We know that the economic decline started in mid-March after 2-1/2 months of solid growth at the beginning of the year, yet that weakness in the second half of March was sufficient to cause Q1 GDP to decline by almost 5%. April was even more dreadful, surely the single worst rate of economic decline on record, as reflected by the historical loss of 20.5 million jobs as just reported. Unemployment claims, filed after the payroll survey week, imply another decline in payroll employment in May, although the recent reopening of some businesses should temper that decline. By June, payroll employment should be positive. How much is unknowable at this point. But the rebound has already begun in May and most investors understand this.
Stock investors have been differentiating between companies seen as beneficiaries of the pandemic and those that have been hurt the most. Technology firms, especially those having seen a surge in business because of the pandemic, are setting new highs, including Amazon, Netflix, Microsoft, Roche and Thermo Fisher, to name a few. That why the NASDAQ, with its top 10 companies representing about 44% of the entire index, is now positive for the year, despite the recession. Company stocks most vulnerable to the shutdown of the economy are still down sharply, including cruise lines, airlines, restaurants, shopping malls, shopping centers, retail stores, entertainment companies, casinos, and such. Investors now seem to be trying to differentiate between those that will recover sooner, those that will take longer, and those that are sufficiently impaired they may never recover. In fact, that’s precisely what we’ve been doing for the past several weeks.
A solid investment case can be made for the stocks that have rallied because of the pandemic, despite their lofty valuations. We all know that Amazon has been capturing market share from brick and mortar retailers. That growth trajectory accelerated during the pandemic and it is highly unlikely that these inroads will be ceded back to traditional retailers. J. Crew and Neiman Marcus have already filed for bankruptcy and J.C. Penny can’t be too far behind. There will be more. Companies such as Macy’s and Kohls will get a temporary boost as some sales shift over to them, but they are still fighting a receding tide. What’s clear is that internet based firms will continue to thrive. So we must try to determine if they are already fairly valued for their strong growth prospects.
An investment case can even be made for the firms hurt the most by the pandemic, such as the cruise lines. The entire industry was shut down by the CDC, which imposed a no-sail order through July 24. I imagined no one would currently consider taking a cruise vacation any time soon, yet the companies report strong bookings for 2021 and the three major lines expect to resume a limited number of sailings this summer. Those bookings can easily be cancelled and the companies remain vulnerable to a return of the virus. Yet, the level of bookings suggest that cruise vacations could return faster than expected. An effective treatment for Covid-19 would open the door to a faster recovery. But the stocks trade at prices that assign very low valuations to their fleet of ships. We see the cruise lines as rather speculative investments at this time, so we are not inclined to venture into this space, but we can understand that those investors who wish to be aggressive could take a chance on these companies.
One area of focus for us has been on those companies that we think can recover sooner. We also look at balance sheets to determine if a company can handle a temporary sizable loss of business until activity returns to normal. One of the most difficult uncertainties is how to anticipate those companies that have the financial ability to pay their dividends, yet choose to reduce or suspend those payouts to strengthen their balance sheets. We think we are in the earliest stages of a recovery, although uncertainty is high because we can still be surprised by the path of the pandemic. However, it should be clear to all that investors are now more comfortable getting back in, as they recognize that economic prospects are improving. And that is the message behind the stock market rebound.
Dr. Charles Lieberman