The Stock Market Climbs a Wall of Worry


By John Nicola CFP, CLU, CHFC, Chairman and CEO

An expression coined in the 1950’s that depicts a sustained stock market rise during a time of economic or financial stress in which stock prices are said to be ascending is a “wall of worry.” This sometimes also results from a herd mentality of investors who “buy on bad news.”

On Friday June 5th, 2020 the S&P 500 reached 3193 a 43% recovery from its recent nadir earlier in the year on March 23rd of 2237 and only 1.14% below where it started 2020. To say that this is a remarkable and unexpected result would be right up there with the 1980 US Gold medal winning hockey team (1000-1 against Finland).

 

S&P 500 Index

As of the end of last year, the Cyclical Adjusted Price to Earnings (CAPE) Shiller PE ratio was at 32 or more than 130% higher than at the bottom of our last major bear market in 2009. That valuation was higher than the peak in 1929 and the second highest level ever. The only more expensive PE ratio was just prior to the Dot Com Bubble in 2000.

Since then, it is likely that, for the year 2020, S&P 500 earnings will be 20% lower than 2019. If that is the case, then US equities are currently at a PE ratio approaching 40. The image that comes to mind of investors climbing a wall of worry seems to resemble a Tom Cruise stunt from a Mission Impossible movie.

 

Cape Shiller Index 2000-2020

Are we experiencing some sort of Covid euphoria driven by expectations of a return to normal a vaccine? Lower unemployment (although still at a post-war record of almost 14% in North America)?

Or is this the proverbial “dead cat bounce” we wrote of earlier that characterizes normal bear markets?

Is there something logical and rational driving these markets? Perhaps there is. Jason Zweig wrote an interesting piece in the WSJ titled This Bull Market Isn’t as Big as You Think in which he showed that the rise in the S&P has been driven by a small number of companies with very high valuations; for example, Zoom up 209%, Amazon 33%, Regeneron Pharmaceuticals 59%, etc. At the same time entire industries are well off their highs. Airlines at 52% may seem obvious but US banks are down 33%, autos 30%, and consumer finance 27%.

Technology has been driving the markets to nosebleed multiples. Besides Amazon, Netflix, SalesForce and Advanced Micro Devices are all trading for more than 50x their expected 2020 earnings.

This means there are still a lot of value stocks with depressed prices.

An additional factor to consider is interest rates. The chart below shows 10-year US Treasury Bond rates for the last twelve months. While they have been rising lately, they are still 120 bps lower than this time last year at .91% (June 5th, 2020). To put this another way, as Warren Buffet has, this is equivalent to a price-to-earnings (PE) ratio of 110 on an asset that cannot appreciate in value when it matures 10 years from now. Safe it might be but cheap it is not. The current yield on the S&P 500 is 1.96% or more than double the 10-year bond yield.

 

10 Year Treasury Rate Overview

Numbers in Canada are more favorable to stocks with the 10-year Government of Canada Bond yield at .72% vs. approximate 3% dividend yield for the TSX; Mind you this is somewhat driven by a combination of banks and life companies whose earnings have taken a significant hit but who have not yet reduced their dividends.

Governments globally will likely do their best to keep interest rates lower than markets warrant until substantial economic recovery occurs. In terms of GDP and unemployment, very few economists are suggesting we will see 2019 levels until at least 2022.  So, low rates may continue to be a tailwind for equities for quite a while.

I remain skeptical of this rapid market recovery and see it as an opportunity to ensure our clients have a truly diversified and balanced portfolio; one that generates consistent cash flow As a result, this is a good environment to be a value investor in all asset classes.

One last warning for bond holders; if  10-year bonds, US or Canadian, were to return to the level they were just two years ago by 2022 (just over 3%)  then those bonds, if acquired today, would lose about 20% of their market value and still pay less than 1% interest until they matured. It does not take much for any asset to be expensive.

As I close, one last sober reminder is the famous quote below from Isaac Newton after losing 20000 Pounds (about $8M CAD today) by doubling down on his investment in the South Sea Bubble:

This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required provincial securities’ commissions.