Is the Market Melt-Up Cause for Concern?
With the market moving back up to close to its all-time highs, the betting would clearly seem to be that everything will be all right and that the V-shaped recovery is well underway. When you look a bit deeper, though, even if those positive assumptions come true (possible, but certainly not guaranteed), there are still reasons to be concerned about where the market is now. Let’s take a look at the details.
V-shaped recovery seems on track
A V-shaped recovery means the economy reopens, jobs come back, and people start spending again. All of those things, in fact, do seem to be happening—and faster than expected. That recovery should be good for corporate earnings and is reflected in analysts’ forecasts. While earnings expectations are down drastically for 2020, analysts have them bouncing back substantially in 2021, which again reflects the expected V-shaped recovery.
So, what’s the problem?
One problem is that when earnings do bounce back in 2021, they are only expected to get back up to the level of 2019. In other words, if everything goes right and we get the V-shaped recovery, then earnings for 2021 will look much like earnings for 2019.
This sounds like (and is) a good thing. After all, 2019 was a good year, and pre-coronavirus it looked like 2020 was going to be a good year as well. If we can indeed get back to 2019 levels of growth and earnings, that would be a significant success.
But another problem is that stocks are valued based on forward earnings expectations. So, if 2021 earnings are like 2019 earnings, then stock prices at the start of 2021 should be similar to those at the end of 2018. At the end of 2018, the S&P 500 was at 2,670. Even if we take the peak earlier in the year, at 2,930, we are still well above those levels. If everything goes right, then we are somewhere between 6 percent and 16 percent above where we were less than a year ago, with similar earnings expectations. In other words, stocks are not cheap.
Another way to look at this situation is to consider the price-to-earnings ratio (i.e., the ratio for valuing a company that measures its current share price relative to its per-share earnings) of the market based on those expected earnings. At the peak in late 2019, the forward P/E ratio was around 21, the highest level in at least the past 15 years. Now it is approaching 23, which again would suggest around a 10 percent premium to the highest level in a healthy, growing economy.
Stocks are quite expensive. And that is assuming everything goes right.
From meltdown to melt-up
The recovery from the meltdown has been the most rapid in history, and rising markets tend to create their own momentum. With the Fed cutting rates to zero and now buying corporate bonds, in addition to the federal government dumping trillions of dollars in stimulus into the economy, you can certainly see how that momentum got established. You don’t fight the Fed, after all.
Looking forward, by 2021 the assumption is that the V-shaped recovery will have normalized the economy. And if the economy is normal, shouldn’t rates move up—even a bit? And if things are normal, will it need ongoing stimulus? If everything does go right, then two of the major factors now driving the market will disappear by 2021, leaving valuations without that additional support. At that point, current expensive levels may look even more expensive.
And, as noted, this outlook assumes everything will go right. As we may be seeing, there is the risk of a second wave of the virus, and we may well see the recovery slow down for multiple reasons. If something goes wrong, even a normal setback, then valuations look even more stretched.
Be careful out there
The virus can remain under control, and the recovery can succeed—and stocks are still quite expensive. At the very least, current stock prices assume everything is going right.
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Posted by Brad McMillan, CFA, CAIA, MAI