How Much Longer?
Insight is published monthly by Strategas Asset Management. Below is the commentary and recommended global asset allocation from this month's edition.
Time flies. It has – amazingly – already been five months since a large share of the global economy was mandated to a near-subsistence crawl. How much longer until we’re back on our feet? Uncertain. While there continues to be evidence of emerging green shoots, suggesting we have likely seen trough activity levels, the persistence of the virus and related behavioral accommodations has dampened commercial appetites and made reopening the economy jagged… at best. For those predisposed to a period of pause, reflection, and relaxation before the traditional chaotic churn of the fall gets underway after Labor Day, there remains much to distract the mind – and even prevent such attention to one’s physical and mental well-being. Inasmuch there seems little to suggest our lives, at least in the short course, will either revert to their pre-pandemic norms (can they ever?) or, at least, evolve to a new, acceptable post-pandemic form. Of course, we know that day will come – eventually – but, for the moment, we seem to be in an almost suspended state.
As always in this forum we aim to focus and comment on the intersection of where we were and where we may be headed from the investors’ vantage point. We remain acutely aware, however, of the material impact the pandemic has had – and continues to have – on a personal and societal level. There have been ~750,000 deaths globally attributed to Covid-19, with ~165,000 tragically occurring in the United States and it is estimated that nearly a fifth of the global workforce has lost work to the contraction in the economy, that’s as many as 30 million in the U.S alone. Those are big numbers. Obviously bad, even in the abstract. Now imagine if it’s you, or are member of your family, that makes the count just 1 higher. Not so abstract anymore.
With this binary severity in mind we see the investor presented with a series of decisions, increasingly well framed by varying time horizons, and most easily assessed – buy our lights – through the prism of valuation.
Admittedly, valuation is a poor timing tool. Rendering it’s utility in the short-term questionable. With prevailing nominal rates effectively anchored to the lower bound, across the curve (and negative in real terms at many points) an argument can even be presented attacking the utility of the exercise altogether. So, in the near-term – in our suspended state – investment decisions seem to be largely informed by the flow (and some frustrating ebb) of monetary and fiscal policy. As we write, the U.S. Congress continues to debate the size, shape, and focus of a fifth trillion dollar+ stimulus package; not whether they should or shouldn’t pass another bill but at what size and to what ends it should be targeted. In the vacuum of Congress’ disagreement, the President has taken executive action (with, naturally, some debate over the legality or efficacy of such a move). We feel it safe to say that unconstrained policy accommodation, regardless of the efficiency of its timing or allocation, is fueling the market’s advance. In the wake of the Financial Crisis we turned to the phase, “bullish ‘til the bill comes due.” We may need to dust it off again… So while it is likely that the bottom is in and clear that the m arket continues to favors flows over fundamentals in the short-term (which is bullish) we maintain that equity prices are ultimately a function of earnings and interest rates – not interest rates alone.
To this end we believe corporate profits will begin to come back into focus as investors look down the road. Despite persistent uncertainty regarding the virus and a lack of visibility on the path to normal (even a new normal), the Street continues to harbor rather optimistic expectations in the intermediate-term (six to twelve months) for a recovery to previous levels of activity, output, and profitability. While fiscal policy, in current form, has amounted to trillions of dollars of income replacement and, in turn, a notable increase in the consumption of goods, it is important to consider that: one, consumption is a far larger share of the U.S. economy (~67 percent) than it is in the aggregation of S&P 500 revenue (~20 percent); and two, absent the President’s executive order which attempts to re-allocated unspent CARES Act funds, the Congress has allowed certain extended unemployment allocations to expire. A greater challenge will be the re-assembly of the S&P revenue stack, heavily dependent on the provision of services. The jaggedness of the reopening has impaired the slope of recovery in the very service economy that helped the Index achieve cycle (and all-time) peak profitability in the second half of last year. The continued dislocation – and a lack of pent-up demand – in the service sector makes us uncertain of the broader economy’s ability to transition from an income-replacement driven recovery to an organic expansion fueled by private sector capital investment.
As the broader equity market presses back to pre-pandemic highs – having already achieved it in some corners, most notably Big Tech – the question is whether corporate profits will hold-up their end of the bargain? By our lights, this outlook is built largely on a “return-to-normal” thesis. The post-Financial Crisis earnings recovery had “return-to-normal” undertones inasmuch as the material impairment of asset prices (the major cause of the earnings decline) was slowly reversed or written off, while traditional economic sectors, notably services, recovered. The post-Lockdown recovery appears to have the opposite construction.
Putting pen to paper, the S&P 500 currently trades ~23x trailing twelve month (TTM) earnings (~$144). A modest (and conceivable) +10% move in the Index from current levels (to ~3,600) and the realization of prevailing consensus CY’20 earnings estimates (~$124) and the trailing multiple on the S&P would eclipse 30x by the end of this year. That will raise eyebrows. For those inclined to keep an eye on the horizon, the same price move (+10%) on next twelve month (NTM) estimates (~$150) would keep multiples at a more acceptable 25x. Bear in mind, the Index has only traded above a 25x multiple in eight quarters over the last 70 years (all of which occurred in the late-’90s and early-’00s).
To put this into context, and as we’ve examined through numerous numerator/denominator pairings, there appears to be two distinct trends driving multiples at any point in time. One secular, informed by: interest rates; but also, inflation expectations; regulation; and, the supply/demand of the capital stock of equities (IPOs vs. buybacks). And, one cyclical, driven by the slope of the earnings curve (or, the outlook for corporate profits). Their combination yields four distinct expansion/contraction scenarios. Each, interestingly has been extant approximately 25% of the time (measured in months) over the last ~70 years. The sensitivity of multiples in each regime varies.
In periods pairing secular and cyclical expansion multiples can expand quickly. This was the case in the late-’90s which saw multiple expand from ~16x, when former Fed chairman Alan Greenspan warned of investors’ “irrational exuberance” in Dec’96, to over 30x three short years later. The application of aggressive monetary policy (globally) arguably provides the catalyst for financial prices to move higher. But, in the absence of a discernible growth driver to attract capital and help the economy to transition from an income-replacement recovery to an organic expansion the economy becomes increasingly reliant on the efficient allocation of the increasing mountain of fiscal “stimulus” to drive earnings higher. So it would seem that there is merit to being bullish… at least until the bill comes due. Such an environment begs for caution or hope (and hope has not proved itself a good investment strategy).
Stay healthy. NB
Strategas Asset Management is a registered investment advisor providing asset allocation, macro thematic, and event and factor-driven investment strategies to pensions, endowments, foundations, financial advisors, ultra and high net worth investors, and as a sub-advisor to '40 Act funds. The Firm operates as an independent, wholly-owned subsidiary of Baird Financial Group.
Nicholas Bohnsack is the President & Chief Executive Officer of Strategas Asset Management and a Managing Director of Baird.