For the markets as a whole, the summer has been pretty good. In the last three weeks, the S&P 500, Dow, and NASDAQ indices have all seen gains of over 7%, and the NASDAQ has broken all-time highs. Although we have had a few pullbacks along the way, the bounce off the March lows has been about as steady a climb up the charts as you will ever see. The markets have achieved the much-touted V-shaped recovery.
The broad economy has shown signs of recovery as well, notably with employment rebounding quicker than expected in both the May and June prints. Likewise, consumer spending has risen sharply since the shutdown lows. Nonetheless, it is too early to say the economy is making a V-recovery. We still have unemployment over 11% (higher than the peak of the great recession), the pandemic has not been brought under control, and spending is heavily dependent upon government relief in the form of unemployment insurance, payroll protection loans, and other aspects of the CARES bill.
The result has been that the markets are only tenuously tethered to the real economy, and valuations have soared. With a very large percentage of companies in the S&P 500 having withdrawn earnings guidance, there is no clear picture of earnings. Where a consensus forecast does exist, the price-to-earnings multiples currently being paid are well above historical averages. At some point, the markets and the real economy will converge. The question for investors becomes, will the economy rebound to meet market expectations (that is, will earnings rise to meet stock prices) or will the markets fall and match the economy (stock prices fall to meet earnings)?
A quick glance at the chart above shows that markets are, clearly, priced for a sharp economic recovery. The price-to-earnings ratio (on next twelve-months earnings) for the S&P 500 is at around 22.7x, which is more than 2.5 standard deviations above its long-term average. Those who argue that the market is a leading indicator of economic activity are correct. When we buy a share of a company, we are effectively buying the rights to future earnings. But if the economy is indeed expected to pick up materially from here, why do corporations still have such limited visibility? Why hasn’t the denominator (earnings) in the P/E ratio started to rise to reflect the improving backdrop?
In sports, the betting line is a leading indicator of who will win the game. Don Shula’s Colts went in to Super Bowl III heavy favorites, but it was no guarantee. Joe Namath famously made a contradictory guarantee and indeed, the Jets won. Just like the betting markets, stock markets can be wrong in their predictions too.
Significant headwinds persist against the continued economic recovery, and a “check-shaped” chart pattern (a quick bounce, then a long plateau of suppressed economic activity) is certainly plausible. The economic crisis was predicated by the public health crisis, and the public health crisis will have to be resolved in some way before the economy can return to something like “normal.”
I am skeptical about the breadth of a continued economic resurgence. Indeed, the first signs of a stall are being seen as California reverses its re-opening and other states are seeing a flattening out of economic activity. As Dan Mahaffee said several weeks ago on The FarrCast, “It’s one thing to call up the 101st Airborne to integrate the schools. It’s another to drag me from my house and make me spend money at Target.” Many Americans are suffering from the disruptions of the pandemic, and the human costs, which we should always remember, have economic costs associated with them as well.
The next obvious question that I’m asked when I express my skepticism is, “Are you getting out of stocks?”, and the answer is simply no. We remain fully invested, but always cautious. In my experience, good investing is guided by patience, common sense, and discipline.
Patience is needed when a market is climbing just as it is needed when a market is falling or stagnant. We are skeptical about the economy and its flawless revival to its former robust self. There is no reliable way to determine when or if a potential setback may come. The wobble we saw earlier this week may be the first cracks appearing, or the markets may climb another 20% before falling 10%.
We also remain fully invested because while reality usually insists on falling somewhere between our hope for best case and our fear for worst case, a good case tends to happen over time. The economy has consistently shown more resilience than feared if given enough time. We have confidence in a complete recovery, and while we think it will likely be a couple of years before the economy returns to 2019 levels, we certainly hope it will happen sooner than we predict. An investor who abandons positions because the markets are “toppy” may well miss out on substantial gains.
Returns on equity investments are driven not only economic fundamentals but also company-specific fundamentals. At Farr, Miller & Washington, we favor companies with sizeable market share in attractive (growing) industries. We like great track records, strong cash flow and excellent management. But above all, we look for companies that have defensible moats around their businesses and the financial strength to endure trying times. On the other hand, we avoid companies that are trading simply on huge momentum swings with “price-to-whatever” ratios. No doubt stocks like these can make traders fabulous amounts of money. Yet many will just as likely lose large sums as the prices come crashing back to earth as eventual execution cannot meet the wild expectations.
Finally, discipline is needed in rising markets to avoid buying stocks solely on fear of losing out. “Past performance is not an indicator of future performance” is more than a disclaimer for us but also a stern reminder. Investing is looking to the future, and while the past is a guide, every time is different. We have to be humble enough to alter course as new information becomes available. Having a discipline keeps investors from jumping on a bandwagon whose wheels are about to fall off. Just as important, it feels awful to buy in a weak market, but that is what a disciplined investor does. Just ask Warren Buffett. Successful investing requires looking through current turmoil to make reasoned, dispassionate decisions about the future. In today’s markets, research must be continuous because with the velocity of market movements, a buying opportunity may exist for just a brief time. For example, the pullback of mid-June really only lasted for two trading sessions.
While the vocabulary of gambling is often used in investing, don’t gamble with your future. Continually ask: what are my possible paths forward? Continually examine your assumptions. In the recent surge, the tech stocks have soared. We own many of those companies based on the conviction of our research that they will continue to perform in a variety of environments. Other stocks have languished, but the beginnings of a rotation into value/cyclicals may have begun with the resumption of industrial activity. We are patient with holdings that may take time to come back into favor as the recovery continues – be it a matter of weeks or a matter of years.
The conclusion of our current American drama is well into our future. The pandemic and economic successes and failures will keep us glued to our seats and investment screens. Throw in a Presidential election in November, a trade war with China, skirmishes in the oil market and at least one more government stimulus plan, and you have a nail biter worthy of Agatha Christie. We are not much for nail biting; it has never made us much money. We favor dispassionate discipline, dogged research, and a clear investment strategy. Defensive investing and getting rich slowly can be boring at times, but that approach suits us very well. Please stay healthy and safe.
Farr, Miller & Washington 