The Quickest Yet Most Hated Stock Market Recovery Ever


Much has been said and written over the past few months about stock markets climbing higher in the face of lower earnings and major disruption from a pandemic. Professional money managers have by and large played it conservatively, with trillions of dollars still on the sidelines sitting in cash. Meanwhile young millennials with no investment training whatsoever have been making out like bandits, turning to trading stocks on their cell phones as an alternative to gambling on sports which was no longer an option. All this courtesy of free government money, lots of free time locked up at home in a pandemic, and new zero commission trading accounts from the likes of Robin Hood.


Stock markets generally (excluding technology stocks which have a life of their own) largely reflect the economy. The pandemic is global in nature and secondary waves of infection are now starting in Europe, Japan, Australia and South Korea. Vaccines and other medical solutions sound like magic bullets but realistically will not arrive in time in adequate volumes to help the situation over the next six months as production and dissemination across the globe will be difficult and take time. The market seems to be pricing in an early end to the pandemic which now seems to be getting pushed out further and further by the day. We have always made the case that the global economy will not recover fully until there is a medical solution, as people do not spend when they are fearful for their safety. If the global economy cannot recover, what does this mean for the stock market?


As of today, stock valuations are elevated relative to current fundamentals and do not discount the downside risks associated with a second round of infections in the fall, delayed delivery of treatments and vaccines, loss or reductions in government income support further bankruptcies and layoffs, higher taxes, explosive debt levels, or rising bond yields. Confidence is high with investors that we are on a direct path to a full economic recovery with low or declining interest rates for the foreseeable future.


Ultimately, though, one must remember that stock market valuations are reflected by price to earnings (P/E) multiples which are largely a function of three key main factors:

As implied in the above diagram the P/E of a stock is a function of interest rates, and lower interest rates will justify much higher P/E multiples than in the past. Lower interest rates alone do indeed justify higher multiples, all else being equal. However, other factors must be considered such as the equity risk premium (ERP) that is appropriate for each security, as well as the anticipated earnings growth rate of that company. Generally, when rates are very low, they indicate trouble in the economy (and therefore Central Banks have lowered interest rates to help stimulate growth). Lower rates then imply lower earnings growth, so the ERP should be correspondingly higher.


Equity risk premiums (ERP) typically range from 3-6% depending on the perceived risk of earnings being reported as anticipated. If the risk to earnings in the economy appears high, as it does today because of the pandemic, you would tend to use a higher equity risk premium, all other things being equal. If the economy appears to be doing well, with low unemployment, good job growth, and little threat of inflation, the equity risk premium used would be on the lower side.


A ‘fair value’ P/E multiple is derived by first starting with the inverse of the expected ERP plus the risk free rate. The risk free rate most commonly used for US stock markets is the U.S. 10 year Treasury bond yield. Therefore, even if you consider interest rates going to 0% (as we almost have today), plus a 3%-4% ERP, will give you a P/E multiple of 25x-33x; while an ERP of 5-6%, which accounts for the higher risk of earnings disappointment, gives you a more normalized multiple of 17-20x, a substantial difference. When you also factor in earnings growth, or lack thereof, which is the third leg of the stool so to speak, those high multiples justified by low rates, even with lower equity risk premiums, can quickly erode.


This explains why Japanese and European markets, even with negative interest rates for years on end, have struggled. By and large earnings growth in those markets has been very scarce as these economies are weighed down by the heaviness of debt on public and private balance sheets combined with an onerous social contract of high wages and generous vacation allowances for workers. So even the lowest interest rates in decades and the lowest of equity risk premiums (as a result of government funded support) have not offset the lack of earnings growth in their economy. The end result being lower P/E multiples and lower stock markets.


Today one could argue that North America is in the same place, with record levels of balance sheet debt not seen since the end of the second world war. Progressive social policies that consider all stakeholders will inevitably lead to higher costs for corporations. You would also have to argue that due to the pandemic, the economic recovery is likely to be more choppy and longer term in nature, rather than the V shape recovery reflected in stock market valuations. The ERP should thus, at a minimum, be towards the higher end of the range around 6% and not the lower end of the range that is being reflected today.


The growth rate at which each company can increase their earnings and the predictability of that growth rate explains a lot about the variability in P/E multiples between individual stocks. It explains why the mega-cap internet tech companies like Amazon and PayPal, with stable and growing earnings continue to march ahead leaving all others behind. With low interest rates, predictable earnings (meaning a low equity risk premium) and an above average earnings growth for these companies, one can see how this translates into record high multiples for these stocks. They have also been the biggest beneficiaries of the pandemic, given their “defensive” moats have only widened with the accelerating digital transformation driven by the lockdowns. For this small and select group that now accounts for a large portion of the stock market, the story has never looked better. Nevertheless, as their stock prices climb higher, the risk climbs that their earnings will not be able to keep pace with lofty expectations, especially as the economy ultimately recovers and competition for their revenues materializes. Ultimately, for this group, the economic recovery may well be their undoing as they give back pandemic sales gains to their bricks and mortar competition and investors find accelerating earnings growth and cheaper valuations elsewhere.


In essence, paying a high valuation for a stock or market today that isn’t justified by improved fundamentals just means that future returns have been pulled forward to today. It is typical for markets to overpay for a great company as everyone wants to own a winner. When this happens it can take years for the company to ‘grow’ into its valuation as earnings of the company need to play catch up. A great example is Microsoft, a great company, whose valuation during the tech bubble of 2000 reached astonishing levels. It took 15 years for its stock price to recover back to those 2000 levels. This is why it is very important to buy stocks well as your future return is dependent on it.


Microsoft stock price chart (2000-2015)

All of the above does not explain why the remainder of the market (excluding technology stocks), is trading at a higher valuation than it was at the beginning of the year when the global economy was growing, unemployment was at the lowest level in a generation, and sales and earnings growth, although not stellar, were robust. We now are looking at the exact opposite: little to negative growth in the global economy, unemployment entrenched at record high levels and the number of companies with positive earnings growth rapidly shrinking.


In the US alone, already over 80,000 small local businesses (with less than five locations) have closed permanently and chapter 11 filings have increased by 30% year over year, according to Yelp. This just goes to show that although central bank money can assist with a liquidity problem (help businesses meet short-term temporary cash constraints), it fails to solve a solvency problem where the real issue is a lack of revenue.


The classic “throwing good money after bad” problem resolves itself with a bankruptcy when the flow of new money is turned off. This would help explain the lack of uptake from the Main Street Lending Program as what business would willingly take on more debt when they don’t have the revenue to service it? Throw in the end of government subsidies as the fiscal well runs dry and the risk of a severe correction look very high. This to us argues for the higher end of the risk premium at 6% or more. So add in 0% interest rates plus a 6% risk premium plus 0% growth (at best) to the mix and the best you can come up with is a 17x price-earnings multiple on $130 in estimated earnings for 2020.


Unfortunately, with the index at 3400, and earnings forecast for 2020 at $130 the current market price-earnings multiple is around 26x, implying an ERP of just 3%. You need to believe that the earnings for 2021 will be higher than at the beginning of 2019 in order to justify the current multiple of 21x on 2021 earnings estimated at $165 (2019 earnings were $164).


Do we believe this? Considering we are close to the end of 2020 and the pandemic still has a grip on 10% of the global economy via travel and leisure, it looks like a low probability. In the US alone, the service industry which now represents 85% of the economy remains at very depressed levels; and this unfortunate trend continues as initial weekly jobless claims are still coming in at a million claims, six months after the pandemic first disrupted the US. With the employment picture looking so bleak, it is unreasonable to assume that spending will return to pre-virus levels anytime soon.

In Summary, we have unemployment levels that are mirroring the great depression, with businesses shutting their doors for good, making job losses permanent. The only hope comes down to fiscal and monetary stimulus measures. However, because of poor management during the good times, countries are already at debt levels that are very stretched and will inevitably negatively impact future economic growth. This indebtedness is a hefty burden that will fall on the already struggling younger demographic.


Interestingly, CEOs of the major publicly traded companies have made recent statements that they are more optimistic now than they were at the beginning, while at the same time unloading shares in their own companies with skyrocketing levels of insider selling at a pace not seen since 2006. $50 billion worth of stock since the start of May has been sold by insiders according to TrimTabs Investment Research.


Yet despite this laundry list of risks, the stock market continues to race back to its previous pre-covid high defying the fundamentals that keep the market in check. To us, the risk of another correction, if the second wave of the pandemic starts to create havoc on the solvency of those businesses that are quickly running out of time, is very high. Too little growth, too much uncertainty and not enough upside to justify buying makes this the quickest stock market recovery in history; and for many professional investors also the most hated.


The Summerhill Team

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