The worst is behind us and have we entered a new phase of economic expansion, or are we on the eve of a new market correction? There is enough data to answer this key question differently. Which tells of its difficulty.
In this analysis, we will see how the market already discounts a full recovery of the economy and any delay in the withdrawal of Covid-19 restrictive measures can cause a risk. Historically, the "market breath" (that is how many shares participate in the rally) has been a good indicator. In the event of an actual decline in Covid-19, a large rotation could begin towards sectors that have hitherto been less considered and outside the most loved ones. The risks posed by the US presidential election are limited.
Back in April, we have written that, after downturns of a similar magnitude to that following the spread of the pandemic, it is to be expected that new lows will be tested in about 70% of cases. A correction, therefore, would not be excluded. This would generate a buying opportunity that is difficult to overlook if multiples revert towards the historic average, given that, as we shall see, both central banks and governments are ready to intervene.
On the other hand, in the eleven American recessions that have occurred since 1949, the markets hit a bottom four-month before the recession ended, demonstrating a tendency to lead the business cycle and not vice versa. On the other hand, turnover and operating profits reached their lowest point between six and nine months after the end of the recession.
The consensus of analysts, strongly pessimistic throughout the second quarter, is optimistic for the last quarter (Q4). The 2021 outlook is decidedly positive and is being reflected in the prices: the twelve-month forward price earning of the S&P 500 reached 22.59, a level that, in the recent past, has only been reached twice: in 1998 and in 2000. Similarly, the ratio between Nasdaq and Russell 2000 is at its highest.
The differential between the yield on Treasuries and company margins is still positive, as it has been since the 2008 crisis onwards. At the moment, it would appear that rates are still "supporting" the markets. It is cheaper to own a share than a government bond. This situation was certainly favoured by the huge, prompt and incisive action taken in March by the Federal Reserve and it is possible that it will consolidate following the changes to the Federal Reserve's mandate with regards to the inflation target (we covered that in the newsletter of 27 August). The transition from a punctual target (2%) to an average target shows the Fed's desire to have its hands free for much greater intervention. The old adage of the markets (Don’t fight the Fed) must therefore be kept in mind.
Meanwhile, in the United States and Europe, governments have finally gone along with central banks' pre-Covid suggestions (which have long gone unheeded) to introduce fiscal incentives in order to ease the task of monetary policy. The reasons that led governments to intervene and the forms of action were the most diverse, but the die is cast for the initiation of joint action between governments and central banks (which, however, continue to intervene massively), a new motto could be coined "don't fight the government". Many are convinced that this change signals the beginning of the end of the precious independence of central banks, however. The theorists of modern monetary theory, of course, rejoice.
Stock markets ignore the slowdown in the American economy
In the United States, in July, economic activity slowed after the overreaction, first negative then positive, in April and May. Sentiment indices show an evident excess of optimism which in 72% of cases since 2006 has been followed by low or negative returns. The optimism on the prospects of valuations is also well expressed by the orientation of the corporate boards to reduce shares buybacks (also due to the moral suasions form the legislator for preserving cash) and the new record number of capital increases (generally justified by the difficulties related to the pandemic) through the sale of new shares.
The "breadth" of the market focuses on growth stocks
The purchases of equity funds on the American market came mainly from abroad. The flow of domestic money, on the other hand, is still negative (YTD), while that towards government bonds is positive. More specifically, on the equity front, the movement is concentrated on indices and on six to seven stocks considered to be winning horses: it is therefore not generalized. If we look at the trend of the last six months, only 57% of the shares are above the 200 days moving average, the breadth of the market is still limited. A confirmation in this sense also comes from the fact that cyclical and momentum stocks are largely outperforming value stocks, which were considered by all, after the lockdown, as the most suitable to survive. As of today, 92% of growth stocks are above the long-term average.
Among the various questions that arise on the prospects of equities, two seem to be the key ones: are the FAANG+s (Facebook, Amazon, Apple, Netflix, Google + Tesla ) in a bubble? More generally, are growth stocks at the origin of a speculative bubble fueled by overconfidence in the recovery?
Compared to the current prices in the markets and compared to the bubbles of the past, the FAANG+ have certainly reached a high level: the search for a further upside must therefore be done with great caution. Growth stocks, in general, present a similar but less exasperated situation.
Is a rotation beyond Covid-19 possible? It depends on social distancing in the coming months.
Beyond the opinions on today's valuations, the most important issue is whether the world is ready for a rotation that goes beyond the Covid-19 season. In other words, is the technology sector ready to give way to the financial, energy and industrial sectors? Will companies in the real estate, utilities and consumer staples sectors be able to recover a place in the sun? An answer can be found by analyzing the trend of "social distancing stocks", the stocks of the sectors that have suffered most from the pandemic and the lockdown (restaurants, cinemas, airlines, clothing, hotels, shops, real estate) which, considered as a whole, they are a good indicator of expectations for the near future. The aggregate of social distancing stocks reached a minimum on March 18 and from there it practically did not move until before the summer when it reached a new low. It would seem that a new bottom has been reached: the next few months will tell us if so.
How heavy is the unknown of the American elections? Not much
The best-case scenario for markets is usually the victory of an incumbent Republican president: historically, on average, the S&P 500 in this case grew 8% between November (election month) and the following January,20 (Inauguration). The worst scenario coincides with the defeat of an incumbent Republican president with an average decline of 7% (again between November and January). The twelve months following the inauguration are, on the contrary, statistically very positive if the Republican incumbent has been defeated and moderately positive in the other cases. Finally, the absolute most positive scenario for the medium term is one in which a Democrat is elected but without control of the Congress.
Volatility in November
At the moment, the candidates seem to have based their respective electoral campaigns on a narrative that allows them to contest the November result: a defeated Trump would probably speak of fraud; Biden, the inability for voters to cast the vote. Both cases are destabilizing for the democratic system and for the markets. The elections will probably be decided with minimal differences and it is possible that they will fuel volatility.
The hot topic of the post-election will be the corporate tax rate: the Trump administration, immediately after the 2016 elections, reduced it significantly; in the event of a democratic victory it could be raised to higher levels (from 20 to 28%, according to forecasts). In the latter case, the impact on valuations would be inevitable with a decline in price-earnings ratios between 4 and 13 percentage points which would bring valuations (and markets) back to historical averages.
Keep an eye on the message from the options market
Finally, it is important to take a look at the options market, in particular the correlation between the VIX Index and equity indices (Nasdaq or S & P500). The first message from the term structure is that volatility is expected to increase, which is pretty intuitive as the November election approaches. The VIX curve itself has a considerable contango (spot price lower than future prices) (16%). Usually, the message from the options world is the right one.
As we said, we like to look at trend of the correlation between the stock market and expected volatility, expressed by the VIX index. The trends should be opposite: when stocks rise, volatility should decrease and vice versa. A divergence in this correlation can signal an imminent trend reversal. There were several significant highs (and lows) identified by this analysis in the past. At the peak of the stock market in 2007, for example, the VIX index recorded a key non-confirmation that proved to be very important. Conversely, when, in 2009, the shares fell to new lows, the VIX index never came close to the highs of 2008, a non-bullish confirmation (that was one of the first signals used in the newborn Simplify 02). Since then we have had several bearish non-confirmations that have anticipated significant corrections. Today we have another bearish non-confirmation.
Finally, when the short-term sentiment is very (excessively?) positive, it should be borne in mind that in the hundred cases of extreme market sentiment (positive or negative, (therefore from January 15, 1996) reported by 'the masses", they were wrong. 99% of the time. I mean they were only right once. Could this be the second?