John Rekenthaler, who is Vice President of Research for Morningstar, wrote a piece recently, The Stock Market Is Not the Economy. In his article, Rekenthaler noted that stock prices are only tenuously connected to general economic conditions. Rekenthaler went on to say, “For one, stocks anticipate future developments rather than dwell on current affairs. For another, neither employment statistics nor GDP growth directly affect equity prices.”
To go a level deeper, I believe that two factors drive markets over time; earnings, including dividends and changes in how much investors are willing to pay for those earnings (valuation multiples).
Morgan Housel of the Collaborative Fund sited a few critical details about these two factors:
- Earnings tend to accrue and compound over time in a way that makes their growth reasonably predictable in a diversified portfolio, because populations grow, and workers get more productive.
- Changes in valuations are wildly unpredictable because they mostly reflect shifts in public moods. But, importantly, they do not compound over time. The P/E ratio falling from 20 to 18 will have the same percentage impact on market prices whether it happens in 2019 or 2049.
That’s it. Every movement – short or long term – is a function of one of those two things.
Where Are We at Today?
I wanted to lead off this piece with this information because the question that I am receiving most these days is, “if the economy is so bad, why is the market so much higher?”
I firmly believe that corporate earnings are heading lower while valuations have skyrocketed higher. This does not mean that the stock market cannot continue to go higher, as noted above, “valuations are wildly unpredictable because they mostly reflect shifts in public moods.” Let me lay out two cases for you.
Bull Case: everything opens in the summer. The unemployed and underemployed go back to work. Within six months, the economy returns to normal close to 2019 levels as the $5 Trillion in stimulus, low gas prices, and 0% interest rates act like lighter fluid that fuels the economy.
Bear case: Unemployment remains in the double digits while underemployment stays above 20%. Everything does not go back to Normal until at least 2021 or beyond when a viable vaccine is developed, and testing becomes more streamlined along with contact tracing methods. There is a relatively large demand shock. The effects of the lockdown on business, especially small businesses that employ most of the country, create depression-like conditions.
Right now, the stock market is firmly reflecting the Bull Case.
Which Do You Want to Play, Offense or Defense?
“When the time comes to buy, you won’t want to. The best time to buy generally comes when nobody else will; other people’s unwillingness to buy tends to make securities cheap. But the factors that render others averse to buying will affect you, too. The contrarian may push through those feelings and buy anyway, even though it’s not easy. All great investments begin in discomfort.”
The above note comes from Doug Kass, Founder, and President of Seabreeze Partners Management. I believe that Kass’s point is why it is so hard to try and time the stock market. The time to get in is when most are fearful, and the time to sell is when most are greedy. This is extraordinarily difficult to do given our own biases.
I have become more convinced that when it comes to portfolio management, my most critical job is to strike a balance between offense and defense. Choosing specific companies and strategies is ancillary within the portfolio management process as these functions won’t help much if I get the offense/defense wrong. I often refer to this offense/defense concept as asset allocation. The split between risk/offense and conservative/defense.
Another way to think about the balance between offense and defense is to consider the “twin risks”: the risk of losing money and the risk of missing opportunity. Eliminating one risk exposes you entirely to the other. Therefore, I try to strike a balance between the two. You are never all in or all out of the stock market.
Similar to the end of 2019 and the beginning of 2020, I find myself looking at data that points to an overvalued stock market where being on offense comes with greater and greater risk.
Sooner or Later, No Amount of Government Stimulus Will be Able to Help the Economy
Neil Irwin in the New York Times shared these insights regarding the pandemic;
- “The world economy is an infinitely complicated web of interconnections. We each have a series of direct economic interrelationships we can see: the stores we buy from, the employer that pays our salary, the ban that gives us a home loan. But once you get two or three levels out, it’s really impossible to know with any confidence how those connections work.
- And that, in turn, shows what is unnerving about the economic calamity accompanying the spread of the novel coronavirus. In the years ahead we will learn what happens when that web is torn apart, when millions of those links are destroyed all at once. And it opens the possibility of a global economy completely different from the one that has prevailed in recent decades.”
One of the reasons why the stock market has rebounded as sharply as it has is due to the government response. In some views, the government has become the lender of last resort. Federal Reserve chairman Jerome Powell has made it clear that the Federal Reserve will do everything in its power to support the economy.
I firmly believe that the government should be there to help support those who have been negatively impacted by the pandemic and subsequent closure of the economy. But for how long can the government keep handing out checks and stimulus funds? Sooner or later, the economy must open back up.
What Does the Future Look Like? Uncertainty
World champion poker player and author Annie Duke stated in her book, Thinking in Bets when it comes to Uncertainty:
- “What good poker players and good decision-makers have in common is their comfort with the world being an uncertain and unpredictable place. They understand that they can almost never know exactly how something will turn out. They embrace the Uncertainty and, instead of focusing on being sure, they try to figure out how unsure they are, making their best guess at the chances that different outcomes will occur.”
What happens when the economy in all 50 states begins to reopen? Do schools start back in the fall? Is there a second way that hits in the fall/winter? How soon do people get on airplanes? How does our relationship with China change due to the virus? Does the November election change the course on how we handle the pandemic?
Erik Anger is a professor of practical philosophy at Stockholm University writes, “In the middle of a pandemic, knowledge is in short supply. We don’t know how many people are infected, or how many people will be. We have much to learn about how to treat the people who are sick—and how to help prevent infection in those who aren’t. There’s reasonable disagreement on the best policies to pursue, whether about health care, economics, or supply distribution. Although scientists worldwide are working hard and in concert to address these questions, final answers are some ways away.”
Niel Irvin, “It would be foolish, amid such uncertainty, to make overly confident predictions about how the world economic order will look in five years, or even in five months.”
There are far more unknowns than knowns, which makes investing even more difficult. Back in March, that was the time to play offense. In my view, the risk/reward valuation favors a more defensive strategy. I could be wrong, and part of me hopes that I am, which means we begin to break through this pandemic, and we determine what our post-pandemic world will look like. Regardless, I would imagine that life will look very different than it did before Covid-19.
Some expert sources were gathered from Howard Marks’s memo, Uncertainty.