Learning the ABC's
According to the U.S. Department of Education, children start recognizing some letters of the alphabet as early as 2 years old, by the age of 5 most children are singing their ABC’s. Proud parents often tell us of their child’s mastery of this sing-along at much earlier ages. A few lucky among us even get to experience the joy of listening to children learn the alphabet by singing their ABC's longer and louder than we previously thought humanly possible. Mercifully, after mastering the alphabet, children's fascination with the alphabet fades. However, there is a strange phenomenon where the fascination with the alphabet reemerges among economists and market prognosticators during recessions and bear markets. Their debates get heated. One economist will forecast a “V” shaped recovery while another pushes back that the economy will not recover, and therefore will be “L” shaped. The debates continue on with a forecast that stock markets will follow a “W” shape over the next year. “U” has also been a popular letter forecast. We’ve enjoyed playing the alphabet game and have been calling for a “V” shaped pattern for stock markets and the economy, a rapid decline followed by a rapid recovery. Our forecast has been that after an initial bounce higher, stocks will continue a slower grind higher but with extremely high volatility. Now that stock markets have bounced back and formed a “V” pattern, we are in need of a new letter to symbolize our expectations of future market movements. After searching the English alphabet, and the Greek alphabet, we could not find a letter worthy of representing our forecast. We expanded our universe of potential candidates to include mathematical notations. It was love at first sight. The tilde nicely represents our expectations for both stock markets and the economy.
The tilde, which is a symbol representing an approximation in mathematics, is a squiggly sideways line that goes up and down but ultimately ends higher. (The tilde is also an important character in the Spanish and Portuguese languages that represents an accent when placed over a letter.) With a potential second wave of coronavirus, geopolitical tensions, social unrest, and a presidential election still ahead of us, it’s no wonder stock markets, and many of us, are a little jumpy these days. Rather than fuel these fears with speculation, let’s get back to the basics.
Stock Market Valuation – Admittedly earnings expectations have and likely will continue to be materially revised as the reopening of the economy progresses. The fears of a second wave and renewed lockdowns are currently dominating the news. There is little talk of an earlier than expected vaccine or highly effective therapy. Both would materially impact earnings expectations. Our valuation process uses the consensus earnings of the investment banking industry as opposed to individual firm’s forecasts, which can greatly vary. History has shown that consensus forecasts have been consistently more accurate. The next chart is a bit noisy but it shows consensus earnings growth forecasts, and the changes to the forecasts, for each year. 2020 earnings growth is expected to fall by 23%, 2021 earnings growth is expected to increase by 29.5%.
When we apply the consensus forward earnings expectations to current stock market levels, we find that the price to earnings ratio is a bit high in absolute terms, but reasonable in relative terms. Record low interest rates (discount rate) and virtually zero inflation justify higher valuations by increasing the present value of future earnings.
We expect markets and economic data are going to be extremely volatile throughout the rest of the year. That's certainly been the experience recently. We will continue monitoring consensus earnings forecasts and compare these to price levels in the market. If markets move too high relative to earnings forecasts we will likely trim equity exposure, as we did in early June. If the opposite happens, we will likely add exposure. We expect the economic picture and macro concerns about the coronavirus and the election to continuously become clearer over the remainder of the year. As this happens, volatility should lessen. That said, expect a choppy ride over the next several months. We've mentioned several times the importance of monitoring credit spreads during this pandemic. While credit spreads don't make the headline news, we continue to believe they are are the single most important indicator of whether the economic response by U.S. Government and Federal Reserve is working. Unlike previous economic collapses, this collapse is not structural. It is a temporary obstruction and the plan is to float the economy until the economy once again becomes self-sustaining. Credit spreads show us the likelihood of companies defaulting on their loans. The higher the spread, the higher the perceived risk of default. When the economy was in shutdown, the velocity of money decreased substantially. People lost jobs and therefore couldn't spend money. This meant corporations were not receiving money and could not service their debt. The government response went so far as to actually send people money. This appears to be working, so long as we don't have to shutdown the economy again.
Yield spreads on High Yield (Junk) Bonds peaked at close to 12% over treasuries, today spreads are below 6%, in line with long term averages. This is a very encouraging sign. Employment and retail sales numbers have also been encouraging. With the caveat that a second wave or sudden spike of the coronavirus could change everything, it appears the economy is beginning to return to its former self. In the meantime, we expect stock markets will continue to react wildly in the short-term to the headlines, but longer-term should follow a modestly upward path.
Searching for smoother air, The GreenPort Team