Looking Into a ‘Back to the Future’ Market
In this article, we review:
- A potential economic and corporate earnings recovery over the next two years
- The impact on stock valuations of a continued low interest rate environment
- How continued Federal Reserve monetary stimulus could be a tailwind for stocks
- How potential volatility in the months ahead could provide opportunity for investors
In the 1985 classic movie, “Back to the Future,” young Marty McFly is thrust back 30 years into the past and spends most of the film trying to get back to the present day. When he finally does at the story’s conclusion, he finds his efforts have changed the course of history, as his mediocre family is now rich and successful and its nemesis, Biff the bully, is washing his father’s car.
With this image in mind, we believe we could now be staring into a “Back to the Future” market for stocks, as gross domestic product (GDP) and corporate earnings scratch and claw over the next couple of years to return to pre-COVID-19 pandemic levels. However once they do, the investment climate could value them higher than before based on the changing environment necessary to get there. This could provide investors with an interesting opportunity, to say the least.
Imagine this for a moment: Following the cataclysmic 2Q 2020 GDP report of -33% annualized contraction, the U.S. economy begins to recover and officially moves out of recession status as most forecasts are now calling for 15%–20% sequential, quarter-over-quarter economic growth in 3Q 2020 and above trend growth of about 3% for calendar year of 2021. At this pace, aggregate GDP would fully recover to annual 2019 pre-virus inflation-adjusted levels by about the end of 2022.
On the corporate earnings front, expectations for CY 2020 are for a massive decline of about 20% for underlying S&P 500® companies (S&P 500 operating earnings per share) as compared to 2019 profits. In dollar terms, this shakes out at about $128 for the year, which, in comparison to 2019 profits of $163, certainly looks abysmal. However, early forecasts for 2021 operating earnings seem to be converging right back in the $163 range.
While this “catch-up” scenario for both aggregate GDP and corporate earnings may at first appear to be a good bit behind the curve for the next two years or so, we encourage investors to consider a picture of the overall environment once pre-pandemic economic growth and corporate profitability levels are re-achieved.
Once they are, we will likely still be looking at a long-term interest rate environment dramatically lower than the last time these GDP and earnings levels were present in the markets, as well as continuing large-scale, open-market asset purchases by the Federal Reserve. Trillions of dollars in fiscal stimulus will also likely have filtered through the economy by that time.
While there has been much talk about stretched valuations in the equity markets, primarily based on a comparison of current-versus-historical price-earnings multiples, the existing historically low, short- and long-term interest rate climate argues a different perspective. That being, with short-term rates close to zero and long-term yields challenging all-time lows (10-year U.S. Treasury yield of 0.58% as of August 10), valuations of stocks need to take into account these low- or no-yielding, risk-free interest rates that remain at unprecedented levels.
The relatively basic but still effective valuation metric, the Equity Risk Premium (ERP) calculation, infers real value for stocks at current price points. The ERP is a simple calculation taking the earnings yield on stocks and subtracting the current long-term, risk-free rate. This helps investors determine how much risk the market is pricing for stocks versus guaranteed interest rates. So in applying this valuation metric to gauge the opportunity in equities, the current interest rate environment plays a crucial role along with stock earnings.
When using the August 10, 2020 closing price of the S&P 500 (3,360) and applying the expected calendar year net profits of $128 on the underlying index companies, the earnings yield calculates to about 3.8%. When subtracting the current 10-year U.S. Treasury yield (0.58%) as a proxy for the long-term, risk-free rate, a net equity premium of about 3.3% remains, a level that has historically resulted in well-above-average equity returns for the cumulative three-year period to follow. It is also our judgment that short-term interest rates will remain at or near zero between now and the end of 2022, and while longer-term rates could edge higher, they will also likely remain within a historically low range favorable for equity valuations.
Then, of course, there is also the consideration that the Federal Reserve will likely extend its monetary stimulus in the form of large-scale asset purchases quite possibly all the way to the end of 2022 and perhaps beyond. This will create additional wind at the market’s back in the form of liquidity and credit support providing for, all else being equal, a stronger case to own stocks and credit-oriented fixed income. Currently the Fed is buying about $120 billion of bonds per month in the open markets.
Is there a precedent to how the market has reacted during a similar type of “Back to the Future” scenario in the past? We say there is, when during the time frame of June 2009 through June 2011, aggregate GDP and corporate earnings were moving upward to fully recover toward pre-Great-Recession levels, against a backdrop of zero short-term interest rates and large amounts of Fed open market activity. Over those two years, the S&P 500 posted a cumulative total return of 45%. So while we are not forecasting stock returns of an equivalent magnitude over the next two years, we do believe double-digit annual returns are certainly achievable given the similar market characteristics. As Mark Twain once said, “History may not repeat itself, but it does often rhyme.”
We also remind investors to brace for short-term market volatility as a myriad of events — economic, political and medical — are likely to play out between now and year-end. This could include COVID-19 vaccine news, fiscal stimulus negotiations in Congress, macroeconomic and corporate earnings data, and, of course, the upcoming November elections. Any or all of these developments could lead to heightened market emotions. However in a potential “Back to the Future” market, such volatility could also play toward investor opportunities.
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