JUNE 6, 2020 MARKET UPDATE

What a difference two months can make in financial markets.  Since the date of our last email update, April 3rd, US stocks (measured by the S&P 500 index) are up over 25%.  The massive volatility that ripped through both bond and stock markets from late February to mid-March has largely subsided.  The question remains as to whether we are at the start of a new period of growth and prosperity or simply in the eye of the storm.  Either way, we felt as though now would be a good time to provide you with our thoughts on the current environment.

What’s happened?

At the time of our last update, the $2.2T CARES Act had recently been signed into law, but many of the provisions / benefits had yet to take effect.  As of today, much of the stimulus money has been paid out in the form of direct checks to individuals, loans to companies through the PPP program and through an additional $600 per week unemployment insurance benefit for individuals who qualify.  In addition to the $2,200,000,000,000 allocated by congress through the CARES Act, the Federal Reserve has supported markets by growing its balance sheet by over $3,000,000,000,000 and counting (we intentionally wrote out the long hand version of the stimulus amounts as the abbreviation for trillion doesn’t seem to have the same effect).  Much of the Fed’s efforts have been focused on supporting credit (bond) markets.  In addition to continuing to buy treasury bonds and mortgage backed securities, the Fed has also taken the unprecedented step to directly support the corporate bond market by buying bond ETFs.  The Fed’s efforts are geared at two specific goals.  First, by buying massive amounts of bonds, the Fed is able to keep interest rates low for mortgages, business loans and other lending products.  Second, the Fed’s backstop has meant that some businesses and individuals with a lower credit rating have been able to access loans when they otherwise wouldn’t be able to without government support.  The ultimate goal of these measures is to help carry the economy through to the other side of the pandemic when, hopefully, economic activity will begin to pick back up.  These massive combined stimulus measures from congress and the Federal Reserve have seemingly done the job as far as the stock and bond markets are concerned.  The S&P 500 has defied gravity in recent weeks.  From its low on March 23rd, the S&P 500 is up over 40%, and is currently down only 2.74% for the year.  It’s hard to believe that stocks are down less than 3% given everything that we’ve lived through during the first 5 months of the year.  Bonds have also continued to fair well during this period.  The Bloomberg Barclays US Aggregate Bond index is up 5.22% on a YTD basis.  While the broad-based bond index has appeared pretty stable, there has been much more volatility among riskier (lower credit quality) bonds.  The Barclays High Yield index, which is made up of those lower tiered borrowers, is negative 5.43% for the year, but it is up dramatically from the March 23rd low of negative 22.3%. 

Our View

Like most investors, we are pleased that stocks have rocketed off their lows in late March.  With that said, our job is not to simply report what has happened, but rather to think critically about WHY it has happened and look for the opportunities and risks that may lay ahead.  From that standpoint, there are a number of issues that give us pause with regard to the current level of financial markets.  Here is a list of some of the potential risks that we see:

• Stocks are not cheap

1. One of the most common metrics that investors and stock market analysts use to determine the valuation of a stock or stock market is something called the price-to-earnings ratio or P/E.  For example, the average P/E for the S&P 500 over the last 15 years is 16.  That simply means that on average, investors have been willing to spend $16 to buy $1 of earnings from the basket of companies that make up the S&P 500.  The current P/E ratio for the S&P is over 50% higher than that average at a value of 24.41.  That ratio is based on an estimate of 2020 earnings.  Many investors, who believe that current prices are justified, will argue that 2020 earnings don’t matter.  Those investors will claim that the stock market is forward looking, and therefore it’s the level of earnings in 2021 and 2022 that count.  Based on analyst estimates for what companies will earn in 2021 and 2022, the respective P/Es are 18.96 in 21 and 16.63 in 2022.  Of course, as with any forward-looking estimate, the numbers have less meaning the further out you go.  Therefore, it is concerning to us that, with all of the uncertainly in the world, investors are willing to pay a premium price today for earnings that are projected two years out.  The earnings estimate that analysts are projecting for 2022 ($185.24) would represent an average annual growth rate of 4.6% over three years compared to the pre-pandemic earnings recorded in 2019.  As a comparison, the average annual growth rate in corporate earnings from 2007 – 2010 was negative 0.85%. 

• The stimulus will eventually run out and/or begin to show diminishing returns

1. The unprecedented amount of stimulus from Congress and the Fed has clearly had a short-term impact.  Anecdotally, it certainly seems as though the stimulus checks that were mailed to many American families have been spent on areas like home furnishings / renovations, technology, appliances and other items consumers could easily purchase online.  While there is some talk in congress of crafting a second round of stimulus checks, it would seem as though a second stimulus check would likely be all in terms of direct payments to individuals.  The additional $600/week or $2,400/month of unemployment insurance has also played a huge role.  Depending on what study you look at, anywhere from 30% to 60% of individuals who have received the extra unemployment benefits are earning more while unemployed than they did while working.  Therefore, it would seem logical that those individuals have been more willing to spend money during this period than would otherwise be the case.  The additional unemployment benefit is set to expire in July, but the number of unemployed Americans is likely to stay at a significantly higher level for the rest of the year and beyond.  Our concern is that consumer spending may be reduced if the negative effects of the pandemic / shutdown last well beyond the temporary simulative measures.

• Large Cap Tech Stocks are running out of steam

1. Stocks in the United States have generally performed much better than stocks around the world.  The return on the S&P 500 (US stocks) before dividends going back to January 1, 2015 is 51.19%.  The return of the MSCE EAFE Index (developed international stocks) is negative 0.07% over that same period.  The significant outperformance of the US stock market index over the last 5+ years has been driven by a small number of large technology stocks.  Those big tech companies are companies that most of us come in contact with on a daily basis.  They are affectionately known as the FAANG stocks (Facebook, Amazon, Apple, Netflix and Google), and they are up over 280% during the same period.  The fact that most stock market indices, including the S&P 500, weight companies based on their size means that the largest stocks that have performed the best have had an overwhelming influence on performance during this period.  The FAANG stocks are all great companies with dominate business models, and none of them are going away anytime soon.  With that said, we doubt that the stocks of those companies will be able to continue to power the US stock market forward over the next 5 years as they have for the last 5.  The primary reason for that is based on current valuation levels.  The FAANG stocks with one substitution (remove Netflix and add Microsoft) are the five largest companies in the index.  The combined stock value of those companies added together is roughly $5.6T.  That value of just 5 stocks represents approximately 26% of the United States economy (assuming GDP of $21.42T).  Once again, you’ll hear many investors try to justify the current stock prices of some of these companies by saying that valuation levels are nowhere near where they were at the peak of the tech bubble in 1999.  That may be true by many of the standard valuation metrics such as price-to-earnings and price-to-cash flow.  However, there are other metrics, such as market cap to GDP, where valuations are far beyond where they were in 1999.  For example, the three big tech stocks that were publicly traded in 1999 (Apple, Amazon & Microsoft) made up roughly 6.5% of the economy (GDP).  The combined value of those three stocks today is almost 3x the 1999 level at 18.6% of GDP.  While small companies are able to grow sales and earnings at above average levels for an extended time, the law of large numbers tells us that these huge technology companies (which all operate in highly competitive industries) will likely struggle to maintain their superior earnings growth rates, which provide justification for their high prices / valuations, in the years to come.   

These are just a handful of some of the key variables that we are tracking on a daily basis that make us continue to lean toward a more cautious positioning.  We could easily extend this list to 10 factors or more that all lead us to a similar view point.  As always, these are simply our opinions and we have no doubt that there are pieces to the puzzle that we are missing.  With that said, our job is not to predict what is going to happen, but rather to help our clients plan for the future.  Based on everything that we see, hear and read on a daily basis, we remain confident that keeping a long-term outlook and proceeding with caution in the current environment is the most appropriate course of action.   

As always, we appreciate the confidence that you have placed in us as your trusted advisor and we welcome your questions at any time.

Important Disclaimer

JPS Financial, LLC is registered as an investment adviser with the Securities and Exchange Commission and only transacts business in states where it is properly notice filed or excluded or exempted from such filing requirements. Registration as an investment adviser does not constitute an endorsement of the firm by securities regulators nor does it indicate that the adviser has attained a particular level of skill or ability.

Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the authors on the date of publication and are subject to change. The information presented does not involve the rendering of personalized investment advice and should not be construed as an offer to buy or sell, or a solicitation of any offer to buy or sell the securities discussed. All investment strategies have the potential for profit or loss.

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