7/13/2020
Although they may appear to be disconnected on the surface, and near-term outcomes are impossible to predict, they’re likely no more disconnected than usual.
One of the more important considerations to keep in mind about financial markets is that they’ve always been forward looking. Economic data, by its nature and difficulty in tabulation, always reflects the past. Folks who sold in March probably don’t need a reminder of this, but many of the better buying opportunities for financial assets have surfaced during past recessions. As such, the state of the economy at the time had little bearing on prospects for future returns—in fact, the two are often negatively correlated. Additionally, by the time the recession is over, the larger discounts for risk assets are often long past.
Credit goes to Professor Jeremy Siegel at the Univ. of Pennsylvania (and author of Stocks for the Long Run) for the continual reminders of this during the time of Covid, but earnings for the next year or two represent a very small percentage of an underlying stock’s valuation (or for that of a broader stock index), when using a traditional dividend discount-type model. Although most investors aren’t modeling valuations constantly, the focus does remain on the future—the past is already done with and an investment’s value at any given point is reliant on longer-term future growth and cash flows. That said, with reopenings already occurring around the country (even if not working out ideally from a medical standpoint, especially during the last few weeks), the broader economy has moved on from deep self-imposed trough, and into recovery.
This recovery will likely be a gradual one, and as we’ve seen over the past few weeks, surprise virus hotspots, or comments from officials, may still result in market volatility. The main question now has moved from ‘if’ a recovery would happen, to still a degree of ‘when’ it would happen, as well as ‘how long’ it will take. The latter remains an open question, with social distancing and societal reluctance putting a damper on V-shaped sentiment. There will likely be additional bad news to come, especially for lower-margin businesses like restaurants and retail, where 25% or 50% of normal volume may not be enough to make ends meet. Additional government stimulus may be necessary (and is likely forthcoming), but there could be further economic damage for more indebted firms or others on the brink. Not every business can be saved—this is the nature of the risk involved with capitalism and unfair and unpredictable events. Just because the government has infused money into ‘fallen angel’ portions of the high yield bond market is not an all-clear signal for no more risk. This may also continue to exacerbate rotations away from challenged sectors, like brick and mortar retail, into new economy industries, such as certain segments of high tech, that have already been in progress prior to the pandemic.
Another factor that has taken a back seat amidst the Covid news is the upcoming election. While many are hesitant to trust early results from polling (due to the surprise outcome that challenged the reliability of polls in 2016), former Vice President Biden has jumped to a substantial lead over President Trump—especially in key battleground states. Aside from the current divisive political landscape, financial market trepidation of a Biden presidency, and possible Democratic takeover of the Senate, are focused on the ‘Biden Tax Plan,’ which includes promises to re-raise corporate tax rates from 21% to 28% (albeit not all the way back up to the previous max 35%), and on the highest personal tax brackets. The direct impact is that a corporate tax increase would lower equity earnings, which lowers fair values. Naturally, with concerns over getting earnings back to normal in 2021, downward shocks aren’t being welcomed. Election probabilities will likely continue to be in the minds of investors through the summer and fall. Historically, recessions have been the Achilles heel of incumbent presidents for the last half-century, regardless of the cause.
Financial market reactions were certainly as extreme as we’ve seen in decades over the past few months. With the medical landscape and prospects for a solution remaining uncertain, it would not be surprising to see volatility persist. As before, near-term financial market results remain generally tied to hopes/timing for a vaccine, further fiscal stimulus, and ‘normalization’ of life (financial and other). However, long-term results have been tied more closely to human innovation and ingenuity, which has been a difficult trend to derail.