Now that the world’s benchmark equity index—the S&P500—has closed in on its pre-pandemic and all-time highs, it’s useful to carefully examine valuations and drivers of market performance. By taking a closer look we can discern what investors collectively anticipate about the future and whether it corresponds to our views. Market internals can also reveal where value resides and where it may be stretched.
To begin, consider the most commonly observed valuation metric, the price-to-earnings ratio. Consensus estimates place S&P500 earnings per share at $128 this year and $165 for 2021. Accordingly, the S&P500 currently trades on 2020 and 2021 multiples of 26.4 and 20.4, respectively, or roughly 23 times in year-ahead earnings terms. Compared to a long-term historic norm of about 16.5 times, today’s market price-to-earnings ratio is unquestionably high. But with bond yields at historic lows, defenders of current valuations counter that equities may not be all that mispriced.
We’ve never been big fans of mechanical relationship between bond yields and market valuations. Consider that the Japanese market multiple collapsed from about 40 times earnings at its peak thirty years ago to below 15 times even as Japanese government bond yields plunged from mid-single digits to zero and eventually into negative territory.
The lesson from Japan’s experience is that to the extent that low or falling bond yields reflect diminished earnings power, they offer little solace to holders of equities. In contrast, if bond yields are ‘artificially’ depressed by the actions of central bankers or global savers, but earnings are expected to rebound, then equity valuations can exceed norms of fair value, at least for a time.
Therein also lies the first answer to what prevailing market levels are telling us about investor thinking: The pandemic-induced recession and earnings collapse of mid-2020 will give way to better growth and higher corporate profits over the next year.
It follows that investors are confident about one of the following: (i) the pandemic curve will be sustainably flattened, (ii) an effective vaccine (or anti-viral treatments) will be developed and distributed, or (iii) even in the face of recurring infection spikes, governments will not again shut down wide swathes of the economy.
Any of those outcomes is possible. Still, experts in the field caution that an effective vaccine and the development of ‘herd immunity’ may be difficult to achieve in the next 12-18 months, typically the longest investors collectively peer into the future. Sustainable curve flattening has been called into question in the past few months in the US or Brazil. Recent flair-ups in erstwhile successful ‘flatteners’, such as South Korea, Germany, Australia or New Zealand, remind us of the risks investors run if they think recurring outbreaks are unlikely.
Most probably, investors don’t think that governments will have the stomach to ask citizens to relinquish basic freedoms again. That view, however, is contrary to what is again the case in places like Victoria, Australia, or Auckland, New Zealand, where renewed shutdowns are in effect. But investor beliefs may instead reflect the social and political realities of larger economies, such as the US or the UK, that probably would struggle to impose ‘shelter-in-place’ orders again.
Also embedded in market levels and multiples is investor confidence that the runup and outcome of the US elections won’t dent economic or market fundamentals. Concerns have mostly centered on a Democratic ‘clean sweep’, which could pave the way for higher corporate income taxes and more intrusive regulation of industries such as energy or healthcare. We note that a hike in US corporate income taxes of 5-7 percentage points is probable if the Democrats wrest control in Washington, as envisaged by polling and prediction markets. Investors, therefore, appear to believe that public opinion polls will narrow as the election nears, a view borne out by history and by some recent indicators that show the Democrats’ lead peaking.
Within the market, styles and factors also shed light on consensus investor thinking. Since the market rally began in late March, cyclicals have outperformed defensives and global stocks have bested domestic ones. Partly that reflects perceptions that foreign earnings may tick higher, as China, Japan and Europe sustainably re-open. A weak US dollar also boosts the value of foreign earnings. And larger capitalization stocks, above all in mega-capitalization technology, skew the results. Technology and consumer discretionary sectors have done best, whereas financials, energy and industrials have underperformed.
Again, the results are consistent with global economic recovery, albeit with shifting winners and losers. Traditional cyclical stocks, such as financials or industrials, have lagged more than might be expected in an ordinary economic recovery. Flat yield curves and concerns about credit quality hamper financials, while uncertainty weighs on capital spending that typically supports many industrials. Makers of capital goods equipment, for example, have not bounced back in the same way as other deep cyclicals, such as airlines. Also, high labor cost companies have outperformed low labor cost ones—this probably reflects the aforementioned strength of the technology sector and companies with solid balance sheets.
Although the global equity market has enjoyed brief episodes of rotation, overall leadership remains intact, with an emphasis on information technology and aspects of quality. For the market to sustain significant gains from here, we believe under-performing cyclicals, non-US stocks and a small capitalization stocks will have to make a greater contribution. Yet that will probably take even greater confidence in benign outcomes, which is hard to foresee.
Overall, the market discounts receding risks of Covid-19 and geopolitical disruptions. Investors have faith that global economic activity and earnings will continue to rebound in the quarters to come. Yet given the well-known unknowns of the pandemic, we are concerned that the market is bordering on complacency – especially because we are now entering the ‘fog of war’ that often accompanies a presidential election. But this time, it will be worse if President Trump undermines mail-in voting or contests the results, or if the results remain unclear for an extended period of time after the election. In any of these scenarios, the combination of the fragility of the market’s high valuations, a sputtering economy and the pandemic colliding with the upcoming flu season will likely tip bullish sentiment quickly in the opposite direction.