Stocks were mixed Friday after retail sales in July continued to show some improvement. Risk-on stocks, those that would benefit from a fast recovery from virus quarantine, have been outperforming the growth stocks that led the bull market since March for the past few weeks. Gains in retain sales and an ebb in new hospitalizations have generated investor optimism that the worst may be over.
But it is hard to be overly confident in that assessment. Yes, hot spots like Arizona and Florida have calmed down. But others have erupted, some coincident with the reopening of schools. School reopening is more a trial and error process than a well thought out master plan. Some schools have already had to switch to virtual learning after Covid-19 outbreaks. Others, more disciplined followers of public health standards, are moving forward. As sports followers have learned quickly from following major league baseball, lack of discipline can have nasty consequences, but proper discipline allows baseball to continue alongside the pandemic.
The optimists may be proven right in the long run. Therapeutics have improved and there seems to be a roadmap developing how to live with the virus effectively. We will learn more shortly. While many public schools, for instance, are reverting to virtual learning, a lot of the private schools are moving forward with in-class study. Some are better equipped to apply public health rules. We’ll see in the weeks ahead how effective they can be.
I hate to use anecdotal evidence. But I can tell you I know over a dozen people who contracted Covid-19. All got infected between February and early April. None since. My circle of friends and acquaintances are largely 50+ and don’t hang out in bars or go to large parties. But my point is that once aware of what was necessary to live safe, all have managed to stay healthy. While there are no guarantees, we know that by taking a few simple steps, we can drastically reduce our risks while still enjoying a reasonably normal life. Yes, we still wake up every morning thinking it is Groundhog Day all over again, but we aren’t locked in the four walls of our homes. We have found ways to socialize safely, get back to work, and adapt. That isn’t true for all. Airline traffic has improved, for instance, but the rate of improvement has slowed dramatically in recent weeks. Airlines are still boarding 70%+ fewer passengers than a year ago. Indoor dining is down 75% as well. Sports are played without fans. Roughly 15% of GDP, including most characterized as travel and leisure, will remain far below normalized levels until pandemic risks are reduced dramatically.
To be sure, the bigger national companies have adapted well. Retailers are doing lots of online business. Restaurants with drive-thrus or robust takeout business can survive or even flourish. But the underbelly of America is at risk. The Congressional stalemate preventing the next layer of relief may turn out to be more harmful than Wall Street currently expects. Congress reacts to crisis. This is an election year. So, members of Congress will be more attuned to cries of economic pain. But with that said, Congress doesn’t act quickly, and even if it does, getting the money flowing will take time. No legislation is likely until late August at the earliest. September and October may not be as economically kind as June and July if no relief is enacted until September.
This week and next are the Democratic and Republican conventions respectively. Great media, perhaps, but little in the way of action. Polls show that the majority of those favoring Biden are really anti-Trump. On the other hand, Trump hasn’t been able to expand his support beyond his base. Thus, there is still no clear path to victory for either side. It is still a contested election regardless of what polls may show. Perhaps that is why Wall Street hasn’t reacted more strongly to date.
I want to switch gears and talk about earnings and stock prices. In 2019, S&P 500 earnings were about $165. This year they were expected to rise to $180+ pre-Covid-19, but now the number is likely to be closer to $125. Next year will be dependent on the timing of a vaccine and the endurance of the virus. Right now, the consensus is about $165 again. In 2022, the first real recovery year (hopefully!), a number close to $200 is possible.
Now let’s look at P/E ratios, always a function of interest rates. The Fed has said it will keep interest rates planted as close to zero as possible until the economy normalizes. 2021? Probably not. But if the economy is not into solid recovery mode by the start of 2022, then the $200 S&P earnings estimate is a pipe dream. If I assume some semblance of normal in 2022, then I will have to assume that, at a minimum, the Fed will have to be taking its foot off the monetary accelerator. Should that happen, it would be logical for 10-year Treasury yields to revert to their 2010-2020 average, a range of 1.50-3.00%. That would imply a P/E ratio consistent with what was experienced during the same time frame, or about 16.5x forward earnings. 16.5 times $200 is 3300 or roughly where the S&P trades today.
In 2020 stocks have risen as earnings fell, because interest rates fell sharply, at least partly due to Fed aggressiveness. My contention is that over the next 2-3 years, as earnings recover from $125 to $200, an increase of 60%, it is quite possible that stocks go nowhere.
That isn’t a prediction for what the market will do over the next six months. If earnings keep recovering and interest rates are planted near zero, stocks could well move higher. But over time, everything reverts to the mean. We could see a year of 20% earnings growth and a down stock market if interest rates rise back to normal quicker than earnings increase.
None of this means to panic. If the market is flat, that doesn’t mean all stocks will move sideways. But it does imply that forward progress from today to the point where normalization is the rule of order, may be hard to achieve. Flat, however, isn’t the worst of outcomes, given the strength of the last two years.
Today, Sean Penn is 60. Robert De Niro turns 77.
James M. Meyer, CFA 610-260-2220