Paulsen's Perspective

Everyone is understandably concerned about the recent surge in COVID-19 cases. Outbreaks in the U.S. have risen to the highest level since the pandemic arrived. Now a primary concern for investors is, will it significantly slow momentum in the economic recovery?

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Trendline analysis is a useful tool for assessing valuation risk and upside potential within the stock market. Unlike conventional valuation tools, it does not directly compare the stock market level to its fundamentals. Rather, it appraises performance relative to time, which indirectly relates price to fundamentals. Why? As Warren Buffet regularly points out, “stocks rise in the long run” because, with a very high probability, economies grow.

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Governmental powers are still trying to put together another economic relief package. However, despite the July expiration of unemployment benefits provided by the CARES Act, here, two-and-a-half months later, U.S. economic momentum is remarkably healthy.

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The nation hollers for more economic stimulus! The President says we need more, the Federal Reserve Chairman agrees, Republicans concur, and Democrats think no one is advocating for enough. The screams for help are amplified everyday by the media. Supposedly, the economy is hanging on by only a thread, desperately waiting for more support.

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With monetary and fiscal policies both running full-throttle, many investors are considering inflation hedges. Some traditional favorites—commercial real estate and energy stocks—have several issues holding them back (e.g., COVID-19 and environmental concerns), even with higher inflation. Cash and Treasury Inflation-Protected Securities (TIPS) may keep pace with inflation but offer little more because yields are so low.

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As throughout the post-war era, valuation tools provide guidance for investors to assess whether the stock market is cheap, reasonably priced, or simply too expensive. That is, looking back over the post-war period, the lowest-valuation quartile typically produced higher future stock market returns than valuations stemming from the highest quartile.

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For many, the stock market rally since March remains suspect. Its leadership has not broadened beyond new-era growth stocks to include economically sensitive cyclical sectors and small-cap stocks. Perhaps, though, leadership in this new bull market is more established than it appears.

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The COVID-19 pandemic rages on, the economy is still officially in recession, almost 8% of the workforce is unemployed, and layoff announcements remain commonplace. Furthermore, downtown office buildings are uninhabited, many businesses are operating far below capacity (e.g., restaurants, hotels, airlines), and corporate profits are much lower than pre-COVID.

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Wall Street and Main Street often appear at odds with each other. However, since they are both importantly tied to the economy, it seems reasonable that sentiment for each would typically be similar. In the long run, both would cheer a healthy economy, and neither would root for recession. 

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Amid an ongoing pandemic, and after years of extremely subpar economic growth, few anticipate the possibility the U.S. economy could be headed for an era of much stronger growth. However, the accompanying chart illustrates a historical indicator that suggests the U.S. may be on the cusp of a prolonged period of healthy economic growth.
 

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Broader stock-market plays beyond new-era technology and communications have been generally matching the overall S&P 500 since it bottomed in March. However, these more widespread market plays—including cyclical sectors, small caps, value stocks, and international investments—seem poised to take a more significant leadership role in this bull market in the coming year.

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Bond yields and earnings are both currently low.

During the post-war era, the stock market has done best when yields have been the lowest (despite the fact that low yields are often associated with poor earnings results). This is illustrated in Chart 1, which shows the S&P 500 average annualized total return and the frequency of negative monthly returns by U.S. bond yield quartiles (1950-to-date).

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There is a widespread, consensus narrative that Wall Street Bullishness is divorced from Main Street Fundamentals. With things so bad on Main Street, the only reason the stock market keeps rising is because of a steady, massive, and unprecedented supply of “Sugar” being provided by both monetary and fiscal authorities. Once the sugar stops, the narrative goes, the stock market party is bound to end badly!

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The emotional fallout associated with the COVID-19 crisis produced an unprecedented reaction—or overreaction—by businesses, consumers, investors, and policy officials, which could play a major role in shaping the economic and financial-market landscape in the coming year.

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History doesn’t repeat, but it often rhymes, and sometimes it “reflects!” Forty years ago, the U.S. was at the tail end of its worst inflationary spiral in history and inflationary fears permeated the behaviors of consumers, businesses, politicians, and policy officials. Here in 2020, after more than a decade of disinflation/deflation, chronically falling/negative yields, and weak/contracting economic growth, economic stagnation fears are rampant and it is like watching a mirror image of 1980.

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The COVID-19 pandemic caused the greatest quarterly and year-over-year real GDP contractions of the post-war era, and corporate earnings should have been devastated. But, as shown in Chart 1, by historic standards, S&P 500 earnings per share (EPS) suffered only a relatively small decline. 

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As the S&P 500 reaches a new high, investors are increasingly alarmed by its valuation. And rightly so! Nearly every traditional valuation measure suggests the stock market is trading near all-time record levels. If conventional valuation models are accurate, the stock market appears to have very little upside potential and, ultimately, considerable downside risk. 

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There are still significant risks surrounding the economic outlook. The pandemic may again worsen this fall or winter necessitating another lockdown of economic activity; without additional fiscal relief, rental payments and business bankruptcies could become overwhelming. 
 

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The good-looking big boys and girls have been touted as the only game in town this year. These large, domestic, safe, easily recognized, fast-growing, and sexy stocks have been the ticket! Straying has been costly—international stocks, small caps, cyclicals, and value plays have all trailed. 

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Last Friday’s employment report illuminated that the U.S. economy continues to recover from its pandemic-induced shutdown. Indeed, the Atlanta Fed GDPNow U.S. real GDP forecast for the current quarter is an astounding 20.5%! Bouncing back from the worst ever post-war economic collapse, the U.S. is headed for some gaudy economic numbers in the contemporary quarter. The question facing investors is what are the implications for earnings results next year?

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