Investors should be pleased to open their April statements - with the stock market having it’s best one-month showing since 1987!
After plunging into bear market territory in record time in March, equities recouped over half of their losses in April - another record. In other words, in the space of just over two months the stock market has experienced what usually occurs over more than a year.
Interestingly, the majority of April’s gains took place in just the first week (chart below). For the remainder of the month (and the beginning of May) stocks have been trading sideways.
The early April move up in stocks occurred as it became apparent we would likely avert a worst case scenario with the COVID-19 pandemic (fingers crossed). This hope increased market sentiment dramatically, from extreme investor pessimism to a more neutral level.
This neutral/sideways market makes sense – and my best guess is that it is a trend that will continue for some months. Some cooling off is needed for investors to digest the long-term economic impact of COVID-19 after the virus took markets on a roller coaster ride through February and March. First, there was the "shock" phase (the first chapter), where the accumulation of bad news dragged equities into a bear market. Then, a "policy response" period (the second chapter) followed where the actions of central banks and governments lead equities to bounce from oversold levels. But no matter how different this time is, markets will still have to go through a period where upbeat economic expectations are confronted with reality (the third chapter). And, that's what we believe is ahead of us over the next few months.
In our model portfolios we are increasing equity exposure (from very low levels) to take advantage of the long-term market upswing, while also adding to Government bonds and US dollars to protect against any near term dips. As well, we are adding to gold and inflation linked bonds to better protect against what we expect will be an inflationary decade.
Many big name ‘experts’ have been left out of the latest market bounce. They point to unprecedentedly bad economic data (record unemployment, record decline in GDP, record decline in consumer spending) and suggest stocks could fall back to previous lows. They may be right, but I don’t think we are going back to the depressed prices we saw in March. My reason – T.I.N.A. (There is no alternative) to stocks.
Interest rates in North America are nearly zero (and in Europe and Japan rates are negative). Normally one could invest in corporate or longer term bonds to earn a return – but with government rates so low, these alternatives provide only a 2-3% return. While smaller investors may be satisfied to sit in cash and wait out the volatility – pension funds, endowments and other large institutional investors with obligations to meet (pensioners to pay), must redeploy capital to earn a return and keep up with inflation.
Low interest rates can also have a positive impact on the price of stocks (skip this section if you don’t like math!). The price to earnings ratio of a stock measures how much the stock is, ‘Price,’ divided by how much the company makes in a year for it’s shareholders (earnings). This earnings number can be either forward looking (predicted earnings over the next 12 months) or backward looking (what the company has actually earned for shareholders over the past twelve months). Looking at the forward P/E ratio historically, we can get a sense of how expensive or cheap stocks are (chart below). The S&P 500 Index (the largest 500 stocks in the USA) currently has a forward P/E of 20.1 vs. the average since 1989 is just 16. This would suggest that stocks are expensive – which makes sense given that the next twelve months earnings will be negatively impacted by COVID-19.
However, P/E needs to be considered in the context of interest rates. While an average P/E ratio of 16 might be justified over the past 30 years (where the 10-year US Government bond rate has averaged 4.95%), today’s much lower rates suggest P/E ratios could go much higher. Under such conditions, stocks could still have more upside.
In closing, we expect the market tug of war to continue – but are much more optimistic about where markets will be a year from now, given the advances in potential virus treatments and the gradual re-opening of the economy.