Is The Current Market Rally Sustainable?

06.17.2020 - Douglas Cohen

The top of mind question following the best two-month gain in the S&P 500 since 2009 is whether such a powerful rally is sustainable despite the immense health, economic, political and social challenges facing the US and much of the world.

An Anti-Minsky Moment

I’ll do my best to answer that question but first a caveat—we are currently living in what appears to be the ultimate anti-Minsky Moment. That’s a nod to economist Hyman Minsky who developed the theory behind what eventually came to be known as a Minsky Moment. Simply put, a Minsky Moment equates to a time of maximum (perceived) certainty—a point of prosperity, synchronous economic expansion, strong profit growth and stable credit markets. The apparent nirvana inevitably leads to excessive risk taking, largely through increased leverage. Alas, something inevitably goes wrong: lenders call in their loans and leveraged investors are forced to scramble to the exits to raise cash as asset prices plummet.

The actual Minsky Moment is thus, paradoxically, the perfect time to sell. The 2008/09 Great Financial Crisis (GFC) was a near textbook case of all this—a particularly dramatic example of how economic and market cycles typically work. Taking things to their logical conclusion, it seems fair to say that the uncertainty inherent to almost every aspect of the ongoing pandemic and its impact on the global economy equates to a point of near-maximum uncertainty. There simply is no historical analogue to this crisis. Hence, an anti-Minsky moment and thus, at least in theory, an attractive opportunity to buy.  

Of course, one could argue that the actual anti-Minsky Moment came in late March as it became clear that the Federal Reserve and Congress were committed to doing “whatever it takes” to save the economy. The speed and magnitude of the subsequent equity rally has likely surprised almost everyone, but it is not without precedent. Indeed, the major US equity indices had 100%-plus rallies in both 1932 and 1933 that proved fleeting. Still, the drivers of the ongoing rally seem more rational than many might suspect. (Ron Sanchez, Fiduciary Trust’s Chief Investment Officer wrote about this topic in his most recent article: Making Connections of the Disconnect). Rightly or wrongly, the key lesson investors took from the 2008/09 GFC was “don't fight the Fed.”  Sure enough, the US monetary and fiscal response to the pandemic is already nearly three times as large as the entire post GFC period, with a high likelihood of more to come.

A Closer Look at the Numbers

As noted above, the underlying dynamics of both the initial sell-off and the subsequent recovery make sense. The traditional market-cap weighted S&P 500 is only off about 8% from its February peak while the equal-weighted index is off nearly 15%. The traditional S&P 500 index is dominated by larger cap companies, most of which have the balance sheet strength and other resources to weather the ongoing storm. That’s particularly true in the case of the tech-oriented companies such as the “fab five” of Microsoft, Apple, Amazon, Alphabet and Facebook that now comprise approximately 20% of the cap-weighted index. These companies and many of their Nasdaq brethren are particularly well-positioned to benefit from the ongoing dislocations related to nesting at home, working remotely, E-Commerce, etc. They are a major reason that, the last 2-3 weeks aside, growth stocks have continued to trounce their value-oriented counterparts. Meanwhile, the stocks that are more representative of the “real economy” have suffered more. For example, the Russell 2000 and the major bank indices are still well off their highs (about 17% and 30%, respectively).  Finally, those stocks most directly impacted by the crisis such as the airlines, cruise lines, retailers that have been closed and were already struggling such as department stores, and oil producers (particularly the frackers) are generally still down at least 40% despite strong recent rallies.

With the caveat that markets routinely both overshoot and undershoot, the obvious question is if the market has already fully discounted the likely economic recovery. With the S&P 500 now at about 17.5 times preliminary 2022 consensus earnings per share of about $180 (very much in-line with the consensus forecast for 2020 back in January and thus a seemingly reasonable approximation of “normalized” earnings), the short answer appears to be “yes” in the sense that the average multiple for the last 25 years has been about 15.5x.

Again though, caveats abound. Price to earnings ratios are extremely blunt instruments and, at least theoretically, investors should focus more on free cash flow-oriented metrics. Historical multiples also need to be framed by the prevailing levels of interest rates and, by extension, other macro indicators such as inflation and money supply growth. In theory, lower for longer interest rates should equate to higher multiples, although there is clearly a tipping point when rates can be so low that they are more of a signal of weak economic growth than anything else (see Japan and Europe). The most bullish case for equities probably rests on the so-called earnings yield—the inverse of the price to earnings ratio. At a current ~5.5%, it dwarfs both anything on the Treasury yield curve and the S&P 500 dividend yield combined, a relatively rare occurrence over time.

Four Equity Market Influencers

Alas, our brief Market Valuation 101 summary wouldn’t be complete without incorporating the equity risk premium that investors demand for owning equities as opposed to securities higher in the capital structure, particularly bonds. And that’s where one must take a view as to how long and to what extent the ongoing pandemic and the resulting economic dislocations will last.

Leaving aside the longer term implications of economic issues such as the dramatic spike in sovereign debt levels and social tensions following the death of George Floyd late last month, these are the four issues that we believe are most likely to influence the equity risk premium over the balance of the year:

  1. Meaningful progress on a vaccine or an effective COVID-19 treatment. Our view is that the consensus expects either of the above to be largely in-place in the first half of 2021. Moreover, the consensus likely expects occasional COVID-19 “hot spots” to occur come late fall and winter, but nothing as severe and widespread as what triggered during the recent national shutdown.
  2. A slow but steady improvement in virtually all economic indicators in the back half of the year as much of the economy re-opens. The market fully realizes that some portions of the economy will remain under extreme pressure, particularly those related to travel and tourism, but the trajectory is expected to be positive almost across the board.
  3. Heightened tensions between the US and China into the November elections as President Trump seeks to blame the Chinese for the coronavirus crisis. While the rhetoric is likely to escalate on both sides, most investors believe that last year’s trade deal will largely remain intact and that, if re-elected, the “practical businessman” side of Trump will ultimately lead him to find enough common economic ground to avoid a bona fide Cold War—or worse.
  4. Speaking of the election, it will increasingly begin to dominate the daily news cycle. At this point, we do not believe the market fully believes the polls, almost all of which point to former Vice President Biden with a sizable advantage in the popular vote and a somewhat narrower lead in the most of the likely swing states. Most publicly available betting odds still view the race as close to a toss-up, with Biden as a relatively small favorite. In terms of the Congressional battle, the consensus fully expects the Democrats to retain the House while the Senate has recently gone from a perceived slight GOP lean to a virtual toss-up. Objectively speaking, we believe the possibility of a Democratic sweep could, at least initially, weigh on the US equity market due to the potential for a fast and sizable increase in taxes and regulation in what figures to be a still-tenuous economic recovery.

To paraphrase Joe Friday on Dragnet, those are, more or less, “just the facts” as we see them. Those with generally more bullish or bearish views than the consensus will likely want to tilt their portfolios in the corresponding direction.     

Written By Douglas Cohen  

The information provided is intended solely to provide general information. The information and opinions stated may change without notice. The information and opinions do not represent a complete analysis of every material fact regarding any market, industry, sector or security. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy, or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.


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