The stock market continues its unrelenting pace with another positive week. The year-to-date gains are up to nearly 5%, despite many headwinds. Let’s debate the bull and bear thesis:
• Interest rates: This has been the primary driver of higher P/E’s. As rates decline, multiples expand. Earnings have advanced in the low single-digit range, at best, over the past 4-5 quarters, while the average P/E has risen from 15x to nearly 20x. However, the 10-year Treasury has dropped from 3.25% to 1.50%. Global short rates were down 70bps in 2019 and are at their lowest level since 2010. The case for higher rates in the U.S. is difficult to see. For instance, Greece is now issuing 10 year bonds below 1%. The fear in 2012 was they would default as rates ballooned to 42%. They were above 8% the following 5 years. Given a choice, most investors would choose a 1.5% 10-year Treasury over many European counterparts. That is not reversing any time soon.
• Tariff wars: One would expect the tariff battles to be relatively subdued during an election season. It’s impracticable to think they would be higher in 2020. Therefore, cross border trade can resume with some level of near-term certainty. Lower tariffs in and out of China should help global trade.
• Demand: This is the third “mini-recession” in the industrial complex over the past 10 years. Inventories are diminished and pent-up demand is out there. With low rates, now is the time to expand factories or upgrade old equipment.
• TINA: There Is No Alternative…fewer options lead to money flowing to the stock market that may otherwise be stored in CD’s or bonds. The Wilshire 5000 Index only has 3,500 stocks in it now. More capital is flowing to a smaller number of options. If one takes out the dead areas of retail, certain auto industries, legacy technology and companies that are not innovating, the list gets even smaller. Winners keep winning and attracting investor flow. This can drive the index figures higher as the big cap leaders aren’t overly expensive relative to their growth rates.
• Federal Reserve: They have openly spoken about letting inflation run above their 2% target, if they can even get there. This means a period of easy money is here to stay for a while. It also adds another level of certainty to the investment landscape. Further, the Repo Operations are making their balance sheet expand again with $423B added already in the last six months alone. The size of the Fed’s balance sheet has a direct correlation to the stock market.
• Commodities: The virus outbreak has led to a slowdown in China. Many commodity prices have collapsed. This major input cost, especially energy, will go a long way toward improving profit margins so long as end-market demand keeps pace.
• COVID-19 – The coronavirus now has a name. The data from China is suspect at best but assuredly lower than the true number of infections and deceased. Many cities have let some people go back to work, but their economy is still well below its historic pace. Supply chains will be disrupted. Energy demand is down 25%. It is estimated travel will be down 35% this year alone. AirBnB stopped taking reservations all the way out to May in most areas in China. The major risk is if this disease doesn’t die off in the warmer weather and/or a cure can’t be developed quickly enough, there will be a lasting impact. How much is yet to be determined. The market is pricing in a bullish scenario and a V-shaped recovery.
• Debt – The amount of capital raised in bond markets has been tremendous. With interest rates this low, the cost to cover this debt is manageable. However, default rates are perking up in quite a few areas like school loans and autos. They are typically the first shoe to drop. The debt bubble can get bigger, but how long before global central banks, ours included, are told no more? Any restriction on companies being able to raise debt would be a massive headwind. Eventually, you have to pay the piper.
• Valuations – While it is true that lower interest rates alleviate high P/E concerns, we have not seen periods with these valuation metrics lead to decent returns over the long haul. Eventually, profit growth has to resume. Previous 20+ P/E markets saw significant declines. “This time is different” is a scary phrase to rely upon.
• Election – Three years ago, the majority of investors were worried about a Trump victory and what would happen to the stock market. Today, the chatter is what the policies of a possible socialist Presidency would bring. Further, the longer the Democratic field is this large, the higher probability of a contested convention. Any dark horse candidate could (re)emerge and quickly throw the market for a loop. Also critical, does anyone have confidence that another four years of Trump would be less predictable? If he goes back to fighting with China and presses harder with more tariffs, the economic landscape can change quickly. There is no reelection to worry about which may embolden him even more. With ultra-high valuations, the downside risk is elevated.
• Investor Sentiment – Although we have yet to hear cab drivers offering stock tips ala 1999, the overall market is over extended relative to history and there are some signs of frothy behavior. Example #1 is Tesla. We have not seen a pullback of substance since 2018. Corrections are healthy.
So far, liquidity, Fed policy and low interest rates are winning this battle. The virus impact is leading to even easier monetary stimulus measures in Asia and could keep rates lower for longer as inflation is non-existent. Leading indicators on the domestic front have bottomed out and are slowly turning up. International indicators are not quite there yet.
Many stocks are generating a few years’ worth of returns in a short time frame. A rebound in the industrial sector is expected, and being priced in today. Top line revenue expansion needs to occur in the not-too-distant future.
Locking in some gains along the way never hurts. Stay true to your disciplines. This market can keep rising but one must make sure to not give these generous gains back.
Oddly enough, the anti-sugar Presidential hopeful, Michael Bloomberg, turns 78 on this Valentine’s Day.
James Vogt, 610-260-2214