Six months ago in the depths of the March meltdown I wrote to you regarding the nature of the market collapse, the governmental and central bank response and the similarities and differences between this crash and other historic market plunges.
We made three observations. First, if you had cash, buying the market seemed to be sensible although obviously risky. We thought equity risk premiums would rise although not to 2008 levels. We believed 60-75% was warranted. Second, we estimated that had COVID not occurred the S&P¹ would have approached 3,675, but we still thought that the market would reach 3,000 or higher in the fourth quarter discounting the recovery of earnings that would be realized in 2021. Third, we thought equity risk premiums would remain elevated 20-25% above their historical levels and that consistent with prior crashes the market could still test its lows between March and the end of the crisis.
As of Sep. 1, the S&P had surpassed 3,500 and has not tested its March lows (I’ll get to the volatility that followed later in the week in a moment). At least as far as the market is concerned, the crisis has abated. At least for the time being, investors seem to be picturing a world in which COVID is an ongoing concern because without a vaccine it is unrealistic to believe that it will disappear entirely with only masks, social distancing, and better treatment regimens. Global economies have produced a technical recession, as delineated by two successive quarterly declines in GDP. Given the dramatic decline in the second quarter of 2020 however, we may not see further reductions. While unemployment is at recession levels, government stimulus has materially softened its impact. Of course future stimulus is still unresolved. Fed and other central bank activity remains robust almost beyond imagination in support of risk markets. There is little evidence of inflation and industries that were hit hard have not spread that economic contagion to those in which demand remains strong.
All this leads markets to focus intently on 2021 earnings and to price stocks on the basis of an elevated equity risk premium and very low interest rates. Current estimates of 2021 S&P earnings per share hover around $170.² Ten year rates are at 0.68bps.³ Using an elevated equity risk premium (what you might expect to earn over the risk-free rate) of 20% over historical levels (by my estimates, about 375 bps) I arrive at an S&P level of 3,300. This is pretty close to where we are at present. This logic would imply that values today are fair and cash should not be deployed in the market until better growth in earnings can be forecast depressing the equity risk premium and improving the level of future earnings. Additionally it will be essential that inflation remains low and subdued. Any material increase in inflation expectations will increase the discount rate and have a negative impact on stretched multiples and the related stock prices.
Credit markets have also proven robust. Despite significant increases in bankruptcies, credit spreads have recovered most of what they lost in March. Again levels appear to be fully valued with not much upside in the current spread environment. Central bank activity is keeping rates low and spreads tight. While I subscribe to the mantra “don’t fight the Fed” I do not think that the corollary is accurate: you should not continue buying as spreads tighten to historic levels. Now is a time to go a bit shorter in duration, locate the spots where spreads have not collapsed as much as they have elsewhere, and most importantly to find managers whose experience and track records reflect an ability to navigate these kinds of aberrant market conditions.
There will be a few important things to consider as we approach the end of 2020. First and foremost is the US election. No doubt this one will be as contentious an election as can be remembered. No doubt that at this stage, the winner is impossible to determine given the potential departure of the Electoral College from the popular vote. I think we can rely on the Fed to continue the policy status quo, however stimulus legislation is very much up in the air (I do believe it will pass, the questions are at what level and to what use). The upshot: expect increasing volatility as we approach the election, in some cases, similar to that we saw at the end of last week. I would expect that up until the eve of the election it will be hard to clearly predict a winner absent some very significant developments that cannot presently be foreseen. Outside of The Economist’s bullish stance on Biden’s odds, most major election forecasters seem to agree. After the election, or longer if the election is disputed, the market will stabilize. The level where it lands will depend on the winner, how a dispute is resolved, and on the policies the next administration adopts. Portfolios should be constructed to withstand increasing volatility into November and investors should refrain from attempting to predict the market direction as it will be easy to get whipsawed under these conditions.
But perhaps the most revealing point is also the most obvious: COVID has accelerated trends that were already driving markets before the onset of the pandemic. Companies that benefit from digitization and increasing connectivity have seen considerable growth in market share, earnings, and stock price. This is not temporary. It is structural. These gains will not continue at the same pace and magnitude of the last few months, but the overall trends will endure.
Few times in history has the old economy evolved into the new so quickly. Old business models resistant to change will suffer and die. New models more in line with evolving consumer preferences and behaviors will defend and strengthen their positions. Shareholders of such businesses will be rewarded. This is not to say that certain companies cannot recover. Nor is it to say that value is dead and growth reigns supreme. To the contrary. A value stock could represent a traditional business for which the transition to digital will generate attractive rewards. On the other hand, a business that cannot change could represent the value trap that investors constantly worry about. It is the application of technology, or better put, innovation, which represents the greatest opportunity for the old as well as the new.
Finally, I do not believe that humans will continue down an inevitable path towards a work-from-home culture that consumes all. Humans create energy when they come together physically. Homo sapiens have always been social creatures. I would go so far as to say that in groups, they are more creative than they are alone. Mentees cannot be adequately mentored by Zoom. Customers want to meet their vendors and suppliers. Human-to-human contact is necessary for our very survival. So cities are not going to die. Office buildings will not become hulking relics of the past. On the other hand, how we live within our cities and how we use our office buildings will inevitably change. The big banks probably do not need to keep empty disaster sites on-call for emergency use as employees can more easily work from home. Buildings probably need to be built to better accommodate the accelerating flow of food deliveries and cardboard boxes from Amazon. Certainly airlines, restaurants, and the leisure industry in general need to reinvent themselves. It will be in this innovation that the winners will emerge and the new and exciting investment opportunities will emerge.
As always, thanks for reading. Please drop me a line if you have questions or thoughts, and follow me on LinkedIn.
Peter Kraus, Chairman and CEO
1 S&P 500 Index, ticker: SPX
2 S&P Dow Jones as of Sep. 1, 2020
3 U.S. Treasury as of Sep. 1, 2020