Important information: The value of investments and the income from them, can go down as well as up, so you may get back less than you invest.
This article first appeared in the Telegraph
This is a strange market rally. There are echoes of the technology-fuelled bubble 20 years ago, but what’s happening today is different. In the dot.com period, market sentiment was almost uniformly bullish, and the few sceptics were, like Cassandra, cursed to be right but ignored. Now it’s the accepted wisdom that the mismatch between Wall Street and Main Street is unsustainable. But still the market rises.
Jeremy Grantham, the founder of the GMO fund management company with a reputation for calling market highs, says the US stock market is ‘lost in one-sided optimism’. He is joined by a long line of hedge fund managers buying protection against the market falls they predict are just around the corner.
Let’s start with the numbers. America’s most-watched stock market index, the S&P 500, is now 39% higher than at the low point for shares in late March. There has never been such a quick rebound from a market fall. The benchmark index has recovered to within 4% of the level at which it started the year and to within 8% of the high point it reached in February. It is 11% higher than it was a year ago.
This seems peculiar to experienced investors. To ordinary people, it looks insane. We are poised on the brink of the biggest economic downturn since the Great Depression, the world’s two biggest economies are not talking to each other, no-one can predict with any certainty that we are past the worst of the pandemic, and the President of the United States wants to send troops to snuff out the greatest social unrest since the 1960s.
As ever when it comes to the market, things are not as black and white as they seem at first glance. The first point to make about the apparently yawning gap between the market and the economy is that there is not one market or one economy at work here. Unlike with the credit crunch 12 years ago, which cast a shadow over all corners of the economy, the coronavirus outbreak is more discriminating in its impact. There are both winners and losers here. Two economies and two stock markets.
The divide is pretty obvious. Telling everyone to stay at home for weeks on end has had a dramatic impact on how we work, shop, eat and amuse ourselves. The pandemic has brought forward years of technological change into a few months. It is unsurprising that the parts of the economy that fuel our digital lives are thinking crisis, what crisis? At the other end of the spectrum, airlines, restaurants, shops, hairdressers, dentists are all on their knees. This is well known.
The significance of all this for investors is that the stock market, in particular the US stock market, is heavily weighted towards the parts of the economy that are doing OK. The technology sector represents 26% of the value of all the companies listed in the S&P 500 index. Add in healthcare, a beneficiary as we seek to avoid a repeat of the Covid calamity, and you have more than 40% of the index. Throw in communication services and you have more than half the market, according to numbers from Credit Suisse.
The next thing to consider is what determines a share price. Two things essentially: the profits a company is expected to earn; and the price an investor is prepared to pay for a share of those earnings.
When it comes to company profits, those three sectors that account between them for half the value of the stock market are expected to see a modest decline this year ranging from just 0.7% for technology to 3.4% for healthcare and 13.5% for communications. That’s obviously a negative but it is a fraction of the hit that sectors like consumer discretionary, financials and industrials are forecast to endure. Profits for these three are expected to fall by 41%, 30% and 43% respectively.
That’s bad news for the companies in those areas, and for their employees. But none of these sectors accounts for more than 10% of the index. The energy sector, in which profits are expected to be pretty much wiped out this year, represents just 3% of the value of the S&P 500.
The second part of the share price equation is also interesting. The price that investors will pay for a share of a company’s profits is only partly determined by the level of those profits today. More important is the long-term direction of those profits. If today’s earnings drop is seen as temporary then it can make sense to pay a high multiple of currently depressed earnings, in anticipation that they rise in future.
This is the bet that investors are placing today. It is why the S&P 500 is valued at 23 times this year’s expected earnings, a multiple that was only exceeded during the dot.com bubble when everyone assumed that things could only get better. Share prices have rallied during the past couple of months because the price investors are willing to pay has risen faster than expected earnings have fallen.
So, you can start to see why the main index that everyone looks out for on the evening news seems disconnected from the bulletin’s other images of burning cars and shuttered businesses. The key question now is whether earnings can rise fast enough to rebalance the share price equation when (probably not if) valuation multiples come back down to earth.
In the short-run expensive shares can stay that way. In the long-term there is no better an indicator of your likely return than the price you pay for an investment. This is a good time to be very discerning about which of the two stock markets you are invested in today.
Five year performance
|(%) As at 5 June||2015-2016||2016-2017||2017-2018||2018-2019||2019-2020|
Past performance is not a reliable indicator of future returns
Source: FE, total returns as at 5.6.20, in local currency
Important information: Investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.
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