Extreme uncertainty is driving investor sentiment as we approach the 2020 elections, and this uncertainty may be driven by more than the voting outcome. A view of the implicit volatility curve on the S&P 500 options demonstrates that Wall Street is pricing in this volatility after the elections and well into December. The reader may draw their own conclusions about what this means, while remembering that the stock market likes neither uncertainty nor constitutional crises.
Covid-19 has put an end to the economy’s expansion at a time when the nation is deeply in debt. According to the Wall Street Journal, “borrowing spurred by years of low interest rates adds up to $64 trillion in consumer, business, and government debt…more than triple the country’s gross domestic product.” This diverts resources into debt repayment rather than spending, which is a drag on the economy. Federal debt alone is now projected to exceed total GDP for the first time in 70 years, compared with only 35% of GDP in 2007 before the Great Recession.
While the economy has improved since its April Covid-19 lows, stocks are still in historically overpriced territory. Unemployment is at 7.9%, and certainly has fallen significantly since its peak in April. But the last available figure for personal income indicates a sharp fall of 2.7%. A vaccine for Covid-19 is unlikely to arrive by the end of the year, while Wall Street braces for a second wave as autumn temperatures drop and seasonal flu reappears. Already in Europe, the number of new COVID-19 cases in the last two weeks has doubled, and in France new daily cases are hitting new highs. New infections in the UK are doubling every seven days, and amid talk of further European lockdowns, new US cases are approaching 7.5 million, with 210,000 deaths, and new cases have increased by at least 10% in over 31 states. The U.S. President’s Covid-19 treatment may suggest that his condition is severe, while further increasing uncertainty over the U.S. elections, now less than a month away.
A pullback in the stock market to more reasonable valuation levels looks increasingly likely, which is understandable given that the prospects for fiscal stimulus look increasingly unlikely ahead of the elections and into the end of the year.
Risk markets have undergone a speculative mania, while at the same time corporate stock buybacks have plummeted, corporate officers and directors are dumping their personal stock holdings, and there is a huge amount of IPO supply hitting the market. It is a dangerous time for risk assets like stocks. Investors bought stocks in Q3 not because of earnings growth, but because of speculative optimism. Relative to one year ago, the price earnings ratio of the S&P 500 has increased dramatically underlying this fact:
At the same time, corporate earnings have stabilized at levels some 25% -30% lower than in 2019, and far fewer companies are even offering quarterly earnings guidance. Many companies are beating estimates by cutting costs and reducing headcount, which is unsustainable. Consensus estimates are optimistic compared with corporate earnings guidance, and, although not impossible to reach, look challenging in the best of circumstances.
2020 U.S. GDP economic growth forecasts are being revised to anywhere between -2.7% and -4.2%, while many 2021 growth forecasts seem wildly optimistic in the +3% to +6.2% range.
The rolling 12 month differential between growth and value stocks is at its highest level ever, bypassing the highs of the 1999 tech bubble. This argues for a pullback in growth sectors like technology, consumer services, and communication services, and a rotation into value stocks. The larger question, however, is still the direction of the broader market into a period of extreme uncertainty. Bear in mind that the Fed has not only committed to keeping interest rates at zero until 2023, but has also committed to attempt to let inflation rise above its long-standing 2% target. Fundamentally, everything depends on federal stimulus. Globally, this year central banks have pumped $8.5 trillion dollars in monetary support by purchasing bonds, while global governments have provided another $11.4 trillion in fiscal stimulus. If the Fed and other central banks slow their bond purchases marginally, investors will slow their stock purchases.
Industry leaders do not seem confident about stock prices coming into the fourth quarter. Corporate executives and officers sold more than $1 billion of stock over the last week, and have been dumping their personal holdings of stocks:
Geopolitical risks are hardly being priced in to the stock market at all. Will China take advantage of American election chaos as a means to advance its designs on Taiwan?
Rating agency Fitch is expecting corporate loan defaults to approach all-time highs. These defaults are most acutely occurring in retail, energy, leisure and entertainment. Further, Fitch believes that Covid-19 is not the only challenge for corporate ratings, as 30% of all corporate downgrades were not predominantly driven by the pandemic. Negative rating outlooks are now at nearly double their mid-cycle levels, meaning that we should expect an elevated number of corporate defaults and downgrades, to say nothing of credit stress in the state, local, and municipal markets. New York State and New York City, for example, were both downgraded last week by Moody’s.
To conclude, the stock market is pricing a return to normal (and beyond) of the world economy, at a time when economic, health, political, and geopolitical risks are elevated. This is not a positive short term outlook for stocks.
Grant Rogers
Posted on 10/12/2020 at 02:17 PM
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