Dennis C. Butler, President
of all guest columns written by Dennis C. Butler, CFA
he last six months have provided an object lesson in the perils of taking the world as it is for granted — something we in the comfortable West have been guilty of for far too long — and assuming that people’s lives, institutions, and societies will continue pretty much as before, albeit while enduring the normal vicissitudes of life. In fact, no one knows what the future holds, whether in matters of economics, investing, or the real world. In our own sphere of competence, for example, last January’s end-of-year market commentary focused on the longevity of the bull market since the Financial Crisis, and analysts pondered what it would take to derail it. With so much loose monetary policy among the major central banks, they were hard pressed to see any reason for financial assets not to remain in favor. At the same time, however, it was widely acknowledged that prices and valuations left the markets vulnerable to significant but unquantifiable downside risks in the event of unexpected political/economic setbacks.
Meanwhile, initial reports of a new illness spreading in China gradually entered the public consciousness, but until cases began to appear in Germany and other Western countries, the news was met more with curiosity than real concern. Some epidemiologists were sounding the alarm, but few lay observers suspected that a pandemic of historical proportions was brewing. Complacency and denial about the SARS-CoV-2 virus muddied the waters, but once the potential seriousness of the public health threat dawned on participants, the reaction in the financial markets was swift and decisive. Fear of an open-ended economic collapse caused a worldwide equity market sell-off. In the U.S. events that could only be described in extreme terms — “quickest selloff in history,” “sharpest single-day decline,” “worst month since 2008,” — provide a glimpse into market psychology during the worst days of the panic. Commodities were hit badly as well, reflecting an expected demand collapse; petroleum futures prices, for example, briefly fell to an unprecedented minus $40 per barrel.
Moving forward a mere two months: on June 3 the S&P 500 completed the best 50-day upswing in the history of that index, and it approached the all-time high reached in February. The NASDAQ, in fact, surpassed its previous zenith and ended June about 4% above its pre-plunge high of February 19. June 30 ended the best quarter for the major averages since 1998, as the Dow Jones Industrials rose about 18%, and the S&P nearly 20%. Reflecting the strength in the technology sector that has been responsible for a substantial part of stock market gains in recent years, the NASDAQ spiked over 30%. Modest but nonetheless surprising early progress in the development of vaccines and treatments for COVID-19 helped to spark a change in sentiment. Relatively positive economic news contributed to the move into equities; statistical releases showed that the pandemic’s impact on employment, housing, and industrial production, while severe, has not been as dire as feared in March. Also helping matters greatly was massive intervention by central banks — including a $3 trillion increase in the size of the U.S. Federal Reserve’s balance sheet — and the adoption of major fiscal stimulus programs in the U.S. and Europe designed to support employment and help businesses survive the downturn. In the midst of a panic one tends to forget how effective such policies can be, but large-scale monetary and fiscal responses do tend to have a positive impact in mitigating the contraction in business activity an economic crisis brings in its wake.
It goes without saying that most observers looking at the markets in mid-March would not have conceived, let alone predicted, such a turn of events. Indeed, sentiment towards the markets among professional money-managers had collapsed; surveys showed that economic growth expectations had fallen to the lowest mark in 25 years. Few expected a rebound anytime soon. Hindsight demonstrates once again just how unwise it is to let big, traumatic events guide your judgement and lead you to make rash moves in the throes of a panic, such as selling in an attempt to “avoid further losses.” Even experienced professional investors forget this wisdom; during the second quarter some hedge funds wagered on a continuation of the market downdraft (through operations that, in effect, sell securities short) and learned to their chagrin that one bout of market trauma is not necessarily followed immediately by a second. Over the long-term, economies grow and stocks generally rise; crises, even pandemics, tend to be relatively short-lived events
Bring Back The Stocks
While policies such as the Paycheck Protection Program and expanded unemployment benefits have been helpful in sustaining workers through this downturn, many businesses, large and small, have been hard hit. This has necessitated a variety of cost-cutting measures, such as layoffs, production cutbacks, salary reductions, and, notably during this recession, working from home. In a touching show of solidarity with their employees, some public company CEOs and directors have accepted significant salary cuts as well (50% in some cases), but before anyone sheds a tear over executive penury, we would point out that many of them have a backstop unavailable to the average worker: grants of additional stock options. Given the share price declines in recent months, the holders of these options could see outsized gains when prices recover, as they have since March, that are well worth the temporary sacrifice in take-home pay. We doubt that public shaming for this behavior would have much of an impact on such people, but we think it is a good place to start.
It is worth pointing out that once upon a time, average employees did enjoy the benefits of ownership of their company’s stock through profit-sharing plans, which are now out of favor. It has been estimated that had one of the big online retailers followed employee benefit policies common in the past, its staff members would now own on average over $380,000 worth of their company’s shares.
Much like the ten-year bull market that emerged from the Financial Crisis beginning in 2009, the notable rise in stock prices since March has been met with a great deal of skepticism. It has been called the “Terminator Rally,” after the unstoppable cinematic cyborg. One well-known fund manager said, “the chutzpah involved in having a bubble at a time of massive economic and financial uncertainty is substantial.” In a recent survey, four of five managers viewed U.S. equities as overvalued, the highest percentage since such polling began in 1998. A similar poll in May found that 70% thought the upswing that began in March was simply a “bear market rally” doomed to reversal. In mid-March, near the bottom of the market rout, sentiment among the managers had collapsed and their allocations to equities suffered the biggest decline on record. Interestingly, in the midst of the rout one broker’s “Bull and Bear Indicator” produced a “buy signal.” It was largely ignored because no one believed the numbers. “A sustained rally requires further macro and market policy moves, plus the belief that the virus is peaking in Europe and the U.S.,” said one fund investor. Sounds logical, but such requirements are seldom met when the world is collapsing around you, and the probability is high that when conditions come to be more to that fund manager’s liking, the markets will be significantly higher.
Although we always take such commentary with a grain of salt, it is nevertheless important to address one complaint frequently mentioned nowadays, namely that there is a “gap between share prices and economic fundamentals.” We would agree that the stock market is considerably less interesting than three months ago, but the assertion by some observers that equities are overvalued now more than ever before seems extreme.
Numbers do indeed tend to support the alarmist view. The relationship between index values and underlying aggregate earnings (a common measure of valuation) lies within the top 10% of its range historically. Based on “forward,” or forecasted earnings, the S&P 500 trades at 22 times (it was at 19 times at the market peak in February, and that was the highest P/E since 2002). Using the “cyclically adjusted” earnings figure (which smooths periodic earnings volatility), the index is valued at 30 times, almost twice its long-term average. At 1.9%, the S&P’s dividend yield is also at the lower end of its historical range.
While seemingly expensive, it is important to note that the figures are somewhat distorted by peculiarities of index construction. Notably, five big technology companies currently account for 20% of the S&P 500’s value (the entire tech sector now weighs in at 30%), and thus have an oversized impact on that valuation-weighted index. The strength of this small number of names explains much of the index’s rise this year (toward the end of June, even after the historic rally, over half of the index components were down by more than 10% for the year). Earnings estimates have also come down — not surprising given the current economic uncertainty — and this inflates the forward-looking valuation figures. Finally, regardless of index valuation, there have been a number of industries and individual companies selling at more reasonable prices.
Earlier we alluded to surveys of professional investors going back to 1998. At the end of that year the S&P 500 stood at 1,279.64. At June 30, 2020 it had risen to 3,100.29, or 142.3% (not including dividends or their reinvestment). So, over two decades, through bubbles, financial crises, health crises, wars, and temporary panics, the stock market produced significant results for genuine investors. The record also indicates that market viewpoints, while entertaining to read, are mostly short-term in nature and really have no relevance to investing, which is inherently long-term.
Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over 33 years and has been published in Barron’s. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at www.businessforum.com/cscc.html.
“Current low valuations reward the long-term view”, an article by Dennis Butler, appears in the May 7, 2009 issue of the Financial Times (page 28). “Intelligent Individual Investor”, an article by Dennis Butler, appears in the December 2, 2008 issue of NYSSA News, a magazine published by the New Yorks Society of Security Analsysts, Inc. “Benjamin Graham in Perspective”, an article by Dennis Butler, appears in the Summer 2006 issue of Financial History, a magazine published by the Museum of American Finance in New York City. To correspond with him directly and /or to obtain a reprint of his featured articles, “Gold Coffin?” in Barron’s (March 23, 1998, Volume LXXVIII, No. 12, page 62) or “What Speculation?” in Barron’s (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at:
Dennis C. Butler
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139
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Revised: July 13, 2020 TAF
© Copyright 2020 Dennis C. Butler, All Rights Reserved