Q2: Bankruptcies, Stretched Valuations, & Market Swings

The second quarter of 2020 will be one for the history books. A global pandemic, struggling race relations, rioting, unemployment, and yet somehow an upswing in markets. The lack of predictability had most ordinary investors scratching their heads.

During the recent quarter, U.S. equities increased 18.5% based on the S&P 500 index. This follows a 22.7% decline in Q1 and brings the 2020 return to a painful but not catastrophic -8.43%.

Recent returns are only one notable extreme from the last three months. Oil price futures traded briefly at negative prices, an event so inconceivable that many computers had not even been programed with that possibility. They were practically giving oil away! On the contrary, gold prices reached new highs.

The VIX volatility index, which measures prices on stock options, in March hit a record high of over 82, slightly higher than the prior record set in 2009. Options are a form of investment insurance, and even professional investors are staying away from them when volatility is high. They seem to have chosen not to sell insurance.

A recent surge in corporate bankruptcies includes recognizable brands: Hertz Corporation, J.C. Penney, Neiman Marcus, Brooks Brothers, Sur La Table, Pier 1, J. Crew, Boy Scouts of America, Chesapeake Energy, Chuck E. Cheese, Dean & DeLuca, and Gold’s Gym.

And the World Bank recently forecast global GDP to decline more than 5% in 2020, triggering the first global recession since the Great Recession in 2009.

Yet with this backdrop, the U.S. stock market somehow increased over 18% finishing the quarter close to record highs set in 2019. Truly extraordinary!

What Does It All Mean?
If Conifer Bay Capital had a simple explanation for why the stock market recovered so quickly amid all the bad news, we would include it here. However, we can’t offer a conclusive explanation.

Investors might be “looking-through the trough,” which means they are ignoring the immediate economic weakness and focusing on a rebound in 2021 or beyond.

The market may be supported by the healthcare and technology stocks that seem to be performing better than other sectors such as banks, energy companies, or retailers.

Low interest rates and a fresh expansion of the Federal Reserve’s balance sheet could be encouraging investors that market support exists.

Investors also may be optimistic that a vaccine to prevent COVID-19 and treatments for people suffering with COVID-pneumonia may soon be available.

It also is possible that the market may just be overvalued. We may be witnessing more “irrational exuberance.” Only with the benefit of hindsight will we know for certain.

Stretched Valuations
Despite the stock market’s strength, U.S. stocks appear overvalued again.

One common valuation metric is the price-to-earnings (P/E) ratio, which calculates current prices at about 21.7x forward earnings. This is the highest valuation since 2001 and ranks more than one standard deviation above the 25-year average of 16.3x.

High valuations don’t necessarily cause the stock market to decline, but they do imply that further stock market appreciation is limited and the chance of another market decline has increased.

We believe valuation metrics like the P/E ratio can be useful in predicting long-term stock market returns. When valuations are around 14x earnings, the return over the next five years has averaged around 10%. But when the P/E ratio has been above 20x, the future returns have averaged close to zero.

For many long-term investors, this may be a good time to shift investments from stocks to more stable value assets. Why now? U.S. presidential elections are approaching. Possible new leadership in the Executive or Legislative branches of government may change economic or tax policies. Uncertainty around coronavirus will persist through the coming winter.

Disciplined investors often make changes gradually. In this high-valuation environment, it seems like a good time to gradually shift from more risky to less risky investments.

Extreme Years vs. Normal Years
One final thought: If your family is feeling anxious about recent market swings, you are not alone. The past six months have been an extremely volatile period for the stock and bond markets.

If it helps to visualize this, look at the number of daily stock market swings of 1% or more. During a typical year, the S&P 500 might have 62 days with large price swings. In 2020, the market has already produced 68 such days of such during the first six months, more than double a typical year.

Periodic surges of volatility are not uncommon, and neither are market declines. Look at the chart below of annual S&P 500 returns (gray bars) and intra-year declines (red dots). Years with good returns often include a decline from the prior peak. This year’s 34% decline from the peak is large, similar to 2008, 2002, and 1987. These “extreme” years, however, were typically followed by “normal” years.

The point: Don’t panic or make impulsive decisions. Families should use this time for productive efforts, like evaluating their portfolio’s asset allocation and diversification, and considering their own spending, saving and investment habits.