|Roman Chuyan, CFA||August 17, 2020|
- It’s one of the most expensive markets of all time, while the economy is one of the worst ever.
- The market prices-in a quick, V-shaped recovery with certainty, forgetting about risk.
The stock market remains elevated, driven by Fed-induced liquidity and stimulus money funneled into stocks. The S&P 500 is now trading around 3380, within a hair’s breadth of its February all-time closing high of 3386. At the same time, corporate earnings declined by around 34% in Q2 from the same quarter last year. These trends have brought valuation ratios to historical highs. In its 150-year history, Shiller’s cyclically-adjusted P/E ratio, now at 31, has only been higher in 2018 and in 1998-2002 (see chart below). The 30% market plunge in the first quarter is but a blip on this chart. The valuation measure that we use in our equity model, the price-to-book ratio, is around 3.8, its highest since 2002.
The US economy shrank by 8.2% in Q2 (32.9% annualized, see chart below), and by 9.5% cumulatively in the first half of this year. This is almost double the 2008-09 Great Recession when US GDP contracted by a cumulative 5.1%, and the most severe recession in 75 years – since 1945 (cumulative -12.7%). The consensus is for the economy to cut the contraction from 9.5% to 6% for the full year. A 6% contraction in 2020 would be in the worst 4% in 140-year history of US GDP.
So, we are witnessing one of the most expensive markets of all time (using the Shiller P/E ratio), while the economy is one of the worst we have ever seen. In theory, the stock market looks forward and can see through short-term issues. However, if it had such foresight, we wouldn’t have 30-to-40% short-term rallies and selloffs. History teaches us that the market is “bipolar” – it overshoots both up and down.
Today’s market is discounting an immediate and rapid V-shaped recovery. This is the most optimistic, best-case scenario – and there’s a chance that it, in fact, happens. But there are serious challenges to re-accelerating the economy after such a severe recession. To name just two, I wrote in my previous, July-31st report that Congress might have created a 30-million permanent “unemployed class” that might be difficult to get back to work. Also, consumer sentiment – which typically leads spending – weakened in July and August after a bounce in June that now looks very similar to previous “early-recession bounces” – see chart above.
To be clear, I don’t know (as doesn’t anyone) the shape of the future recovery – V, L, W or whatever it may be. But pricing-in a V-shaped recovery with certainty seems dangerously overconfident. It’s as though market participants forgot about risk.