How does the stock market stack up in this recession compared to previous recessions, and what do forward price/earnings ratios (PE) and interest rates tell us?
Both the pace of the stock market index moves, and the pace of the economic data changes have been staggering. It’s only May and so far this year, we have seen a 30+% sell off, followed by a 20+% rally. Meanwhile, in the middle of this historic rally, the economy set more history, by losing 30 million jobs in a little over a month. Needless to say, this is nothing this world has ever experienced. The pace of the economic fallout is off the charts compared to what we have seen in previous recessions.
As incredible as all that has been, the amount of action put in place by the fed has been just as impressive. The size of the balance sheet increase is jarring and again like nothing else we have seen in our history. So how does this get us to PE ratios? Well recently, we are hearing again and again that stocks are pricey or overbought, which might be the case when you simply look at a PE ratio. However, when you consider the Federal Reserve actions with the forward PE ratio, they are right in line.
Consider this chart below, as bonds rally, so do forward PE, and they are lock step with one another.
Lower rates directly give a tailwind to asset prices by creating lower borrowing costs going right into the bottom line for companies with debt, lowering default risk. The problem with a monetary controlled environment is that it can fuel the extremes of both low volatility and extreme high volatility in stocks. Historically, bond values and equities values move opposite each other, however when they move the same, that’s when volatility increases as evident even before the March 2020 sell off.
Why is this current macro environment a problem for diversified investors of bonds and stocks? First of all, the historical trend of buying bonds with equities as your hedge no longer provides a hedge so investors need to search for other means of diversification. Secondly, the market becomes even more dependent on a government bailout and investors are left waiting for liquidity from a monetary stimulus in order to curb volatility.
So how do we move forward? I am cautiously optimistic, while understanding the challenges of the current environment. For example, the Covid-19 virus still has many unknowns. The positive unknowns include the fact that more people have been infected than previously thought, which would mean the virus is much less deadly than previously thought, and we are that much closer to “herd immunity,” thus reducing the next wave on an economy reopen. Treatments are currently being be developed quickly and such development of drug therapies to treat the disease are showing promise that could reduce the death rate significantly. Finally, the home run scenario would be for a vaccine to come to the market sooner than expected, and it is looking more and more like this may not be an unreasonable accomplishment. But, I’m not ready to push all in, as there are a few unknown negatives that could be life changing for humans forever. Whether or not you can get it more than once, there have been conflicting reports on this. Usually when you can be immune from a virus when your body produces antibodies for that virus and is immune from being infected again. If you can catch it more than once, it would mean there is no herd immunity. What might be really happening in terms of catching it again is that you never really went positive or the more devasting potential effect, a highly mutational virus. If there are many point mutations that occur in the way in which the virus enters your cells, it could mean that we never really get over Covid-19. Thus, the virus becomes another seasonal/regional illness that we try to catch up with a vaccine, but never really can like the flu.
The economy still also has many unknowns. Some regions are opening, others are not. How long until we are open everywhere? Will there be a second wave of corona once everything is opened? How will consumers change after this is over? What will the impact be for leisure and entertainment? And finally, if things were not confusing enough already, we have an election in six months, which will simply add fuel to an already volatile fire.
We could see a return to volatility before this is over, and if this plays out like 2008, we could see VIX above 50 before the economy stabilizes enough to start to see steady jobs and economic growth.
So, what is the solution? Given the fact that stocks of certain industries have gotten crushed and might remain that way, index investing could be dead. Finding single stocks to perform in this new economy will be key. However, investing in such a basket of stocks will require risk management and for that I like to use a hedge on my stock picks. Bonds have proven to be maybe not as risky as stocks but yet still not really hedging investors. Thus, more bond exposure for a conservative investor helps dampen portfolio volatility but not necessarily risk. This all leads us back to the need for stock picking and a hedged portfolio. It’s crucial to be able to pick the winners and losers in this time, and its crucial to be able to protect against a prolonged slowdown in the economy that drags asset prices lower by also trading volatility in a portfolio of stocks and bonds.