Those seeing the glass as half full pointed to better than expected second quarter earnings (reported during the third quarter), meaningful progress on a coronavirus vaccine, continued month-to-month improvements in macroeconomic indicators, and growing confidence that April 2020 marked the pandemic trough. Those on the pessimistic side pointed to widespread COVID-19 case resurgences, questions about the pace of the economic recovery, continued geopolitical turmoil, back-to-school anxiety, election uncertainty, and extended stock valuations when compared to depressed, COVID-impacted earnings expectations.
Against this backdrop, global stock markets continued to climb a “wall of worry.” In the U.S., the S&P 500 Index increased nearly 9% (price appreciation plus dividends) during the quarter, rising over 50% from the March 23rd low. While marginally positive year-to-date and within close striking distance of the February 19th high of 3,394, we still find it difficult to breathe a sigh of relief as memories of the first quarter’s 34% decline are ingrained in our minds.
Outside the U.S., the story was similar, though once again less dramatic to the upside. Global stock prices, as measured by the MSCI All Country Worldwide Ex-U.S. Index, increased 5.6%, ending the quarter down 7.6% on a year-to-date basis. Shifting our focus to the longer-term outlook, which is where we believe our clients should be focused, there are reasons for optimism despite many unknowns. The topics of tax rates, geopolitical turmoil, racial injustice and myriad other challenges are not likely to fade away. That said, while fully acknowledging the potential for various scenarios to derail stocks, we find ourselves, on balance, to be more constructive in our outlook for equities for three reasons.
First, as we stated in the prior Commentary: “Fed is doing everything it can and then some to support the economy. While potentially inflationary and negative for the U.S. dollar, Fed action is bullish for
risk assets, including stock prices. As the old market adage warns, ‘Don’t fight the Fed.’ Such advice is worth noting right now.” We repeat it here because our conviction behind this idea has only increased over the last few months as the Fed has signaled interest rates will remain lower for longer. In addition, we believe that the Fed’s decision to raise the inflation target it uses to trigger rate increases is bullish for equities.
Second, we are optimistic about the global battle against COVID-19. The medical community is learning, iterating, and improving the effectiveness of its treatment of patients suffering from the virus. Communities adhering to medical guidelines on masks, social distancing, and good hygiene are seeing encouraging trends with infection rates.
Third, there are multiple vaccines in late stage clinical trials, with expectations for FDA approvals
als by year-end, and widespread vaccine distribution later in 2021. The more these positive trends continue, the higher the likelihood for continued economic recovery, falling unemployment, and a reduced chance of a second wave driving widespread shutdowns.
Finally, expectations for corporate profits are rising. At the end of the second quarter, analysts were calling for a 22%+ decline in S&P 500 Index earnings for 2020. As of the writing of this newsletter, they now estimate a 19% decline. Furthermore, estimates for 2021 earnings have been rising for the last four months. COVID-19 is obviously the key driver behind 2020’s dramatic earnings decline, with the most
pressure coming from rising loan defaults hurting bank earnings, falling energy prices (due to weakening demand), and a precipitous fall-off in travel and leisure spending. At the same time, earnings in other segments of the market, including technology and health care, proved far more resilient.
In fact, the positive dynamics mentioned above, assuming and hoping they continue, paint a market backdrop of continued, month-to-month sequential macroeconomic improvements. Should this happen, and assuming COVID-19 vaccines prove to be effective, we see further upside to 2021 earnings estimates as depressed sectors recover and the resilient sectors’ earnings remain on track. A major pillar to the bear argument against stocks is that valuations are extended relative to history. However, if 2021 earnings expectations prove to be accurate, not to mention conservative, the market’s valuation looks quite reasonable at 20x price-to-earnings. This holds particularly true in such a low interest rate environment.
In conclusion, with interest rates at all-time lows, bond prices near historic highs, and a credible case for continued progress in the fight against COVID-19, we cannot help but take note of the relative attractiveness of equities. Onward we head, up the wall of worry whilst not daring to fight the Fed.