The outbreak of the corona crisis has left many of us feeling disconnected from friends, families, and work colleagues. Changes in the way we shop, work and play have occurred as a result. This is not the only disconnection that has occurred, however. Financial markets are also feeling disconnected – disconnected from the economy, disconnected from value, and disconnected in size. We consider each of these market disconnections and what implications there are for investors as a result.
Disconnect #1: Between the economy and the market
There has been a lot of talk about a disconnect between the economy and the equity market. The US stock market has risen a staggering 32% from its low on March 23 in the past two months. It now sits just 13% below its record high. All of this while the unemployment que grows at an exponential rate!
We don’t believe the disconnect is as stark as this picture suggests for two reasons.
First, price leads the fundamentals. The fact that the market is zigging while the economy zags isn’t really strange or unjustified. In fact, if we cast our mind back to around the middle of February the apparent disconnect was working in the opposite direction. The market was collapsing while the economic data was blithely printing robust unemployment rates. As late as March 7th, the Bureau of Economic Analysis said the US had an unemployment rate of 3.5%. By then the market had already fallen almost 20% from its peak! Price was leading the fundamentals.
Secondly, this is truly a different situation we are in. We are seeing unemployment rates rise in the US from 4.4% to 14.5% in just one month not because there is a major imbalance in the economy but because the government told us to stop – stop working, stop spending, stop travelling, stop socialising. That is what we did and that is what is being reflected in these data releases. To look at these data as a gauge for where the stock market should be right now is misleading.
It would be like telling a runner to stop and then criticise her for not making her weekly distance target. It doesn’t make sense and it is not useful. The more important question is how fast will she be able to run after having some time off? Several weeks shouldn’t be a problem. Several months may be difficult, but doable. More time than that can be a problem given the loss in conditioning that results.
The economic data that will be released in the coming months will be far more useful in informing us on how much conditioning the economy has lost during the shutdown. Two facts point to a favourable outcome in this regard. First, the period of enforced hibernation has been far shorter than initially expected. That will help ease the pain when we start moving again.
Second, the condition of the global economy going into this crisis was better than it was going into say 2007 and the global financial crisis. Debt levels among US and European households were not as high; the banking system globally was healthier; and valuations in most housing markets were not as extreme.
So, if it is not the fundamentals, what has been driving stock markets?
Chart 1 shows a tight relationship between the US stock market and US financial conditions. In other words, the $20 trillion in fiscal and monetary support thrown at the global economy in response to the crisis has significantly eased financial market conditions in the market. Easier financial conditions are a necessary pre-condition for an economic recovery to take place.
Chart 1. US Financial Conditions and S&P 500
Disconnect #2: Between value and growth
Another disconnect that become even more apparent over the past few months is the disconnect between growth stocks and value stocks.
This disconnect is not too surprising. In a low rate, low inflation world, growth stocks tend to perform better. Value stocks tend to do better when inflation is higher and when yield curves are steeper providing support to the banking sector. Investors, rightly in our opinion, are pricing in the view that inflation will remain low over the near to medium term. The latest Bank of America Fund Manager Survey confirms this. It shows a net 23% of respondents think value will lag growth going forward. That’s the most bearish stance on value stocks taken since late 2007.
Chart 2. US S&P 500 PE
Chart 2 shows the current price-earnings level of the US equity market in relation to its long-run average. Today’s high PE level for the US equity market reflects the high weight in the index to growth sectors such as information technology. The more value-oriented financials sector makes up just 10% of the US S&P 500 Index.
Some caution is warranted when using valuation metrics like price-earnings. History is littered with examples of how bad market valuation is as a timing tool. In December 1996, then Federal Reserve Chairman Alan Greenspan warned of “irrational exuberance” in the market based on what he viewed at the time as excessive valuations. The following three years saw the S&P 500 almost double in value.
It is interesting to note that annual earnings growth has been negative 30 times since 1930. In 23 of those 30 years, the stock market rose. On eight occasions, when earnings growth was down double digits, the S&P 500 rose by double digits. The market thinks beyond the current years’ earnings. The price of a stock today is the sum of its future cash flows many years into the future discounted by an interest rate. So, earnings will be bad this year, but they will bounce back over the coming years. And, the interest rate we use to discount those earnings will be much lower than at any other time in history and is likely to remain so for the next few years.
The surge in price-earnings valuations and the disconnect between growth and value has led many to suggest we are back to the dot com extremes of 2000. The data does not support this point. Chart 3 shows the difference between the PE of the Russell 1000 Growth Index and the Russell 1000 Value Index. As can be seen, we are a long way from the disconnect experienced during the tech bubble.
Chart 3. Disconnect between value and growth
Disconnect #3: Between large and small companies
A final disconnect that has been very evident in the current environment is that between large and small companies.
The point to note here is large companies are benefiting from their ability to adapt to the radically different landscape. Large companies have more scope to move production, gain access to multiple sources of capital, and can more easily re-engineer systems, processes and supply chains. That is usually not available for small companies.
In addition, and unfortunately for the capitalists among us, we are also in an environment where the definition of too big to fail is being extended beyond the big banks – it now seems to include big auto companies, big cruise companies, big airlines. With the help of the Federal Reserve, the US Government is supporting big companies by buying their debt. Small companies don’t tend to use the bond market as a source of funding. So those that do go bankrupt will likely be those that are too small to rescue.
Chart 4 shows an interesting relationship between market size, weight to technology and year-to-date returns. Using the weight to technology as a proxy for growth, we can see the better performing markets are those that are more growth oriented and are larger in size.
Chart 4. What if the market was small or didn’t have tech?
The key takeaway for investors in this environment is to go big and go growth. The low interest rate environment will continue to support valuations and will be more beneficial for growth style markets, sectors and companies. Value style markets, sectors and stocks have traditionally generated returns for investors by distributing income more than through capital gains. Generating an income from yield will be more of a challenge in this environment. This will be particularly apparent for banks who tend to profit from borrowing at short term interest rates and lending at long term rates.
For global investors, the markets that are likely to do better in this environment are the US, Japan and Canada. Europe and the UK will struggle given their defensive qualities (both have around 16% in financials). Australia is more a blended market and so sits somewhere in the middle.
We continue to believe small companies will find the current environment difficult. Smaller cap stocks are often seen as a barometer of investor sentiment and tend to be among the first to recover in an economic upturn. The level of dislocation this crisis has caused, however, is likely to weigh more heavily on those companies with the least flexibility to adapt.