Anyone looking at the equity market over the last two months wouldn’t have suspected the world economy was in suspended animation as countries battled a global pandemic. Belying America’s underlying challenges, the S&P 500 rallied 36 per cent from its March 23 bottom (about a week after the US lockdown commenced) through May, leaving the index of blue chips off a scant 5 per cent for the year. The divergence begs the question, does it make sense to own equities now?
Cresset evaluates the equity markets from several perspectives. First, of course, is valuation. Is the market cheap or expensive? While valuation is not a good timing tool, we know that cheap markets tend to outperform expensive markets over time. Second is the economic backdrop: if equity markets are fish in an aquarium, then consider this the water temperature. Is the economic environment conducive for risk taking and profit making? Third is liquidity, the availability of money to borrow, spend and invest. Abundant liquidity promotes risk taking; market selloffs, like the 28 per cent plunge between February 20 and March 22, are fueled by a worldwide clamor for cash. Fourth, psychology is an important shorter-term contrarian metric, particularly at points of extreme optimism or widespread fear. Fifth is momentum: a cheap market confirmed by buying historically has been an open invitation to invest and to profit.
Let’s evaluate where the equity markets are today based on those metrics:
Valuation Grade: C. Equity markets are neutrally positioned from a valuation perspective, although given the collapse of 2020 earnings estimates, we’re forced to use trailing and current statistics. Market capitalization as a share of GDP, a measure favored by Warren Buffet, is macro metric that has been useful historically. That vantage point shows the market as slightly overvalued, about 10 per cent higher than its long-term median.
Enterprise value to EBITDA (EV/EBITDA) is one of our favorite measures, because it treats equities as cash generating entities after adjusting for cash balances and debt. On this basis, small cap stocks, as represented by the Russell 2000, is the most expensive major equity category, trading at more than 18 times cash flow, or a cash flow yield of about 5.2 per cent. On that score, the S&P 500 is offering a cash flow yield of about 6.3 per cent. International developed and emerging markets are offering cash flow yields of 10.5 per cent and 11.1 per cent, respectively.
The cyclically adjusted price-earnings ratio (CAPE) has been one of the most useful tools of market valuation. Popularized by Yale professor Robert Shiller, CAPE uses real earnings per share (EPS) over a 10-year period to smooth out fluctuations in corporate profits that occur over different periods of a business cycle. Historically, the CAPE ratio has been a good predictor of the market’s subsequent 10-year performance. It’s an integral component of Cresset’s long-term capital market assumptions. On a CAPE basis, the S&P 500 is currently 21, suggesting a 6+ per cent annualized 10-year return, based on history.
Our valuation metrics suggest equity holders stay the course, despite the most recent equity market run up in the face of troubling economic conditions.
Economic Backdrop Grade: D. You don’t have to be an economist to know the economy is awful. Nearly 30 million Americans are out of work and real GDP is expected to plunge at an annualized rate of 34 per cent this quarter. The 2020 labor market drawdown – the share of the workforce losing their jobs – is the steepest and deepest labor market decline in modern economic history. Consistent with economists’ forecasts, the New York Fed’s Weekly Economic Index, which measures real economic activity at a weekly frequency, is the best way to stay up to date with the most current year-over-year quarterly growth projection. The latest reading implies the Q2/20 economy will be 10 per cent smaller than Q2/19. We’re hopeful spending will slowly pick up as states reopen. Meanwhile, American manufacturing and production are in retrograde.
Liquidity Grade: A. The financial crisis of 2008-2009 was, in retrospect, just a drill for the COVID-19 pandemic and the Federal Reserve learned well from that experience – it has done a great job in its role of lender of last resort. We were impressed when the Bernanke Fed ramped up its balance sheet from $900 billion to $2 trillion inside a period of 18 months. We were really impressed when the Powell Fed expanded bond buying by $3 trillion in a matter of weeks. The prospect of a global economic shutdown precipitated a run on capital markets as investors raised cash. The Fed’s actions – its liquidity injections amounted to 30 per cent of GDP – quelled panic selling and stabilized the stock and bond markets. Thanks to those efforts, and those of Congress to get checks into the hands of individuals and small business owners, Cresset’s liquidity measures are robust. Only stock market volatility remains in the tightest quintile of its historical range.
Psychology Grade: B. Investor psychology is a contrarian indicator in which a market, in the near term, represents the intersection of reality vs expectations. History has shown it’s much easier for reality to outperform bearish investors’ poor expectations than it is to hurdle ebullient expectations from overly optimistic investors. Bad news and poor markets weigh on investor sentiment while making prices more attractive. Historical data demonstrate the S&P 500 returns more than double the following year in a foundation of widespread bearishness, as surveyed by the American Association of Individual Investors (AAII). The latest AAII survey suggests that investors, while pessimistic, are not extremely so, which argues for a neutral equity position. Pessimism among international investors is at its highest point since the financial crisis, which suggests there could be near-term equity opportunities abroad.
Momentum Grade: B+. While economists argue over a V-shaped economic recovery, equity investors were treated to an abrupt V-shaped market rebound within a span of three months. The relative S&P 500 return against 3-month Treasury bills favors the S&P 500 after briefly breaking down. Market breadth, the share of companies participating in the rally party, has not benefitted from the same enthusiasm, suggesting some weakness. Only one-quarter of NYSE stocks are currently trading above their 200-day moving averages. The Smart Money Index (SMI), a technical metric that analyzes trading in the first half hour (“dumb” = retail) and reverses the sign and adds in the last half hour (“smart” = institutional). It suggests the market bottom is behind us. During the financial crisis, SMI bottomed in October 2008, five months before the broader market reversal. This year, the Smart Money Index bottomed at the end of February.
When we put it all together, we conclude those invested in equities should stay invested. International and emerging markets are best positioned from a valuation perspective, but momentum is a powerful force and momentum currently favors large-cap, growth-oriented equities. We will be looking for momentum cues from the international and emerging markets as indicators to shift capital in those directions.