Inorganic shutdown leads to inorganic recovery
By performance, the S&P 500 recently had its best month (August) since 1938- driven by technology growth stocks! That’s good, right? That is bad news. Technology stocks are pricey. Also, history rarely provides repeats in quick succession. So, expect the next wave of investor support to produce an upswing in companies that will do best after a vaccine is discovered. Such companies may have been hurt the most in the downturn. Such “value” companies have historically outperformed growth stocks in the early stages of an economic recovery. In this case, that recovery should begin to shine in 2021. We are 17 weeks away from 2021.
Easy Comparisons. The Cares Act and Liquidity as a Lag Effect
Easy comparisons from this shutdown year are setting up value stocks for 2021. According to Bloomberg, a recent survey among economists shows a consensus opinion that U.S. GDP will advance over the next four quarters as the effects of the pandemic and civil protests fade. This projection shows U.S. GDP springing upward over the next four quarters as follows: +18% in Q3 of 2020, +6.5% in Q4 of 2020, +5% in Q1 of 2021 and +4% in Q2 of 2021.
Future S&P 500 Projected Earnings Shaped by the CARES Act
For 2021, S&P 500 earnings are predicted to come in between $165 to $177 after declining to an anticipated $146 for 2020. Given the lag effect of the Coronavirus Aid, Relief and Economic Security (CARES) Act stimulus money, some optimistic analysts suggest S&P 500 earnings could reach $200 next year. To support this estimate, analysts point to the following data. While 20 million people lost their job during the shutdown, 10 million new jobs have been created in just the last four months. In addition, quick action by the Federal Reserve Board to lower interest rates has created increased disposable income for millions of working Americans by lowering their monthly mortgage payment. In addition, the Cares Act-not only saved millions of small businesses and employees, it incidentally, stabilized the stock market, expanded the average American savings rate and produced a pool of liquidity that should continue to affect the economy for years.
In the midst of the February through March downturn growth stocks such as technology stocks became the defensive darlings of wall street as investors sought companies with the very best balance sheets. To illustrate, Apple, traded at 40 times trailing earnings. As a result, its valuation is now equal to all 2000 companies making up the Russell 2000 index. With reflation values of this magnitude It was just a matter of time before a correction occurred. So, is the current correction in technology the precursor for a double dip recession or just a pause while other sectors catch up? Here are five reasons to remain confident in the recovery.
- The CARES Act, an uncommonly large federal fiscal stimulus program, more than offset the decline in earnings projected from a mandated economic shutdown, no such program had even been tried. As a result, the size of this fiscal stimulus package was 2.2 times the size of the stimulus provided during the 2008 financial crisis, 3.6 times the support provided after the 1980-82 double-dip recessions, and 7 times greater than during the aftermath of the dot-com meltdown.
- Businesses acted quickly. The immediacy and certainty of the shutdown caused businesses to cutback labor and operational costs in order to save profitability. As projected declines were managed, companies were able to mitigate the size of their losses. Many companies raised liquidity through inventory liquidations. Moreover, an unprecedented sum of reduced materials orders was observed. Managers did everything possible to survive the unknown.
- Leading into the shutdown, unlike other recessions, households were in good shape. The effects of the 2009 great recession caused people to keep debt levels very low. Also, going into the shutdown, jobs were plentiful. The Trump tax cuts helped. So did rental and mortgage forbearance programs. The household savings rate advanced 20%. Consequently, consumers weathered the shutdown in an uncommonly strong position.
- As with consumers, corporations went into the pandemic shutdown in great shape. To illustrate, the net debt to EBITDA (earnings before interest taxes depreciation and amortization) ratio of corporations was near its lowest level in at least 30 years before the shutdown. So, despite the biggest-EVER blow to real GDP, the impact to corporate earnings was surprisingly mild.
- Looking forward, with household savings rates near 20%, mortgage rates at all-time lows, and years of household and corporate debt reductions achieved, if public attitudes toward the future turn optimistic the best is yet to come. People invest when they view the future in positive terms.
So, despite 2020’s largest U.S. GDP decline ever, a rapid earnings rebound ensued. This explains much of the recovery, both the descent and the rebound.
Positive Technical Signals and the Lag Effect
Now that the NASDAQ and S&P 500 indices have moved beyond their previous highs, from a technical point of view, a new economic era appears to have begun. This is good news. Recoveries typically last much longer than recessions. The first year of a recovery (now) historically provides significant market upside.
Last week the chairman of the Federal Reserve Board announced that in order to offset a decade of inflation-fighting strategies in a deflationary world, the Fed now plans to allow the economy to run hot for a few years. In effect, this means higher inflation will be tolerated. Savers will lose as interest rates will be managed to remain very low. Fiscal policy, however, will continue to support the equities market.
Doing the Math
Since a price-to-earnings multiple of 24 seems fair with interest rates remaining low, the question turns to earnings. What will the S&P 500 earnings be for 2020 and beyond? In March of this year the oncoming shutdown caused some analysts to expect S&P 500 earnings would drop to $126. This is down sharply from a year-end projection of $177 in January. More recently, a new estimate puts S&P 500 earnings at $146 for 2020. A 24 multiple of the S&P 500 expected earnings of $146 produces a fair S&P 500 value of 3504. The S&P 500, as of this writing, is trading at 3372. If S&P 500 earnings hit $177 in 2021, a multiple of 24 would produce a year-end result of 4248. Even a 20 multiple would produce an S&P 500 value of 3540.
COVID-19 Case Rate Dependent Recovery
Much investor thought surrounding a market rebound assumes an early vaccine. Seven differentiated vaccines are in phase-3 trials now. Federal planners are already making plans to distribute a first-available vaccine as early as December of 2020. While the initial AstraZeneca trial data struggles with possible complications, the national COVID-19 case rate is declining by about 20,000 cases per day per month. We’ll see how the winter months develop. If an alarming second wave develops it could slow the recovery.
Questions Beyond Covid-19 and 2021
Several questions may give insight into the recovery. Will all this Covid-19 fear abate as the Boomers find a vaccine solution? Are the Millennials entering their prime home-buying years just when mortgage rates spur demand? If both occur simultaneously will our national refocus on domestic considerations produce a more sustainable growth in GDP? Will this growth be enough to reduce federal debt levels? Meanwhile, will technology rebound even while value stocks begin to outperform during this early stage economic recovery?
As a result of these questions and many more we are optimistic and feeling good about our current asset allocation.
Best Regards,
Vaughn Woods
Vaughn Woods Financial Group, Inc.
2226 Avenida De La Playa
La Jolla, CA 92037
959-454-6900
www.vaughnwoods.com
Investors should be aware that there are risks inherent in all investments such as fluctuations in investment principal. Past performance is not a guarantee of future results. Asset allocation cannot assure a profit nor protect against loss. Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed. Views expressed in this newsletter may not reflect the views of Bolton Global Capital or Bolton Global Asset Management. The information provided is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. VW1/VWA0253