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BMT Monday Market Insights – June 1, 2020

Market Insights

Top Weekly Themes

  1. Employment is Key to the Economic Recovery. Unlike past recessions, temporary layoffs have accounted for the vast majority of job losses.  Anything that resembles a “V-shaped” economic recovery will rely on workers being able to quickly return to the labor market.  In April, 18 million of the 20.6 million people who lost work said that their job losses were “temporary,” according to the Bureau of Labor Statistics.[1]  However, according to a paper recently circulated by the National Bureau of Economic Research, 42% of workers experiencing recent layoffs will suffer permanent job losses.  Perhaps the reality lies somewhere in between, but the large gap between each scenario presented above underscores how difficult forecasting the trajectory of the recovery truly is.  For now, it appears as though the market is pricing in a relatively quick labor market recovery.
  2. For Long-Term Investors, the Opportunities are Clear. Since the Financial Crisis, there has been one clear winner within equity markets.  Large Cap Growth stocks have significantly outperformed, leaving more diversified equity investors with buyer’s remorse.  The staggering performance divergence between large/small, value/growth, and U.S./international has created a commensurate valuation divergence.  Small cap, value, and international stocks are all one to two standard deviations cheaper than average when compared to large cap, growth, and domestic stocks. Stock valuations are not a good market timing tool, and extreme valuations can persist for many years.  In the near term many things other than valuation can impact performance – the economic cycle, news flow, and investor sentiment.  However, starting valuation has an extremely high correlation to average annual returns over the subsequent decade.  So, although we do not know when valuation extremes will correct themselves in the near term, we believe that over the next 10 years, the cheaper asset classes offer more attractive return profiles.  Therefore, we advocate maintaining allocations to these asset classes at our recommended strategic weights even though they have underperformed in recent years.
  3. S&P 500 at a Key Technical Level. The 200-day simple moving average is considered a key indicator by traders for identifying the overall long-term market trend.  Often, the 200-day moving average serves as a support level when the price is above the moving average or a resistance level when price is below it.[2]  Last week, U.S. stocks breached this key level (3,000), only to lose momentum heading into the weekend.  If stocks fail to hold this key price level, it could be a signal of future weakness, while a decisive break above would indicate a higher likelihood of persistent near-term market strength.

[1] BCA Research, Inc.

[2] Investopedia

Returns Table

Week (%) YTD (%) 1-Year (%) 3-Year (%) 5-Year (%) Div Yield (%)
Equities
S&P 500 2.8 (5.4) 10.3 33.1 58.3 1.91
Russell 1000 Value 4.5 (15.7) (3.4) 7.6 23.2 2.95
Russell 1000 Growth 1.6 4.2  23.0 59.6 93.4 1.07
Russell 2000 4.0 (15.6) (5.5) 5.7 20.0 1.59
MSCI EAFE 5.3 (13.1) (3.3) 1.7 6.8 4.1*
MSCI Emerging (0.4) (16.4) (3.6) (1.0) 5.3 3.2*
Week YTD 1-Year 3-Year 5-Year Yield 
Fixed Income
Bloomberg/Barc US Aggregate 0.0 5.1 9.8 16.0 21.2 1.40
Bloomberg/Barc US High Yield 2.0 (4.7) 0.8 9.5 23.3 6.97
Bloomberg/Barc Muni Bond 0.4 1.2 4.2 12.1 20.3 1.62
Bloomberg/Barc Global Agg. Ex U.S. 0.6 (0.4) 3.3 7.8 15.2 0.82
Week YTD 1-Year 3-Year 5-Year Current Level
Commodities
Crude Oil (WTI) ($/bbl) (0.6) (44.8) (43.0) (32.3) (41.6) 33.7
Natural Gas ($/mmbtu) 6.8 (16.5) (29.3) (44.8) (32.5) 1.8
Gold ($/ozt) (0.4) 12.8 34.2 35.2 44.2 1,713.3
Copper ($/mt) (2.0) (14.3) (11.4) (6.9) (13.7) 5,278.5
1 Week Ago YTD 1-Year Ago 3-Years Ago 5-Years Ago Current Level
Currencies
Euro/USD 1.09 1.12 1.12 1.12 1.09 1.11
USD/YEN 107.82 108.68 109.53 111.25 124.24 107.63
Pound/USD 1.22 1.32 1.27 1.28 1.53 1.23

As of May 28, 2020 (close)
*Dividend Yield For MSCI EAFE and MSCI EM are from 4/30/2020.

Chart of the Week

A Fork in the Road – Stocks and Earnings Diverge

Click the chart to enlarge it.

2002-05-29_stocks_earnings_divide
Sources: Charles Schwab; FacSet, Inc.

Key Takeaways

  • Stock prices and earnings expectations usually move in the same direction. Since the market bottom on March 23, the two have diverged.  This kind of deviation is not without precedent, but it is an unusual occurrence.
  • In 2008 the S&P 500 dropped peak-to-trough by 56% amid a 33% decline in forward earnings estimates. In 2020, forward earnings estimates have fallen by about 20% – do we think that is enough given the economic damage that has been done?  In truth we don’t know, but that is clearly what the market is betting on.
  • To return to a normal relationship, either the market needs to move lower, or earnings expectations need to move higher. Which do we believe is more likely?
  • In our view, pressure on earnings expectations is likely to continue, meaning that the stock market will need to carry an ever-increasing price-to earnings (P/E) ratio for current (or higher) price levels to be sustainable.
  • Record low bond yields may encourage a higher than normal (P/E) ratio in the near-term, but depending on perpetually higher valuations to propel stock prices higher is risky. We would like to be more confident in a durable earnings bottom before assuming sustainable new highs in the equity market are imminent.

Commentary

As companies continue to withdrawal guidance, it becomes increasingly difficult to forecast the trajectory of corporate earnings.  The charts below use some historical context to determine what might be a reasonable expectation for 2020 earnings, and what that would then mean for equity market valuations.

If earnings were to follow a similar downward revision path when compared to the last two recessions, S&P 500 companies would earn a total of $119 per share in 2020.  Thus far, the earnings decline has been steeper and more abrupt given the nature of this recession, however we are seeing some signs of stabilization.  Using $119 as a full-year 2020 estimate, and assuming the S&P 500 is able to maintain its current price level (~$3,000), the resulting trailing price-to-earnings ratio would be 25.2.  For context, this would be the highest trailing P/E ratio since the Tech Bubble.

We want to be clear that this analysis includes certain assumptions that may or may not prove accurate.  However, we believe it is important to put the current market rally in the context of both past recessionary periods and current fundamentals.  It is always possible that investors are willing to pay an extremely high price for equities given present levels of central bank intervention.  It is also possible that earnings recover more quickly, and $119 per share proves to conservative.  The bottom line is that at current market levels, investors are counting on either an improving earnings picture, or significantly above average market multiples.

2020-05-29_S&P500_PE
Sources: FactSet, Inc; BMT
2020-05-28_chart3
Source: Strategas Research Partners

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