Light At the End of The Tunnel. Stay Bullish.
After the unprecedented Covid-19 inspired equity market downdraft in late February and March, U.S. stocks staged a remarkable second quarter rally, the best in more than 20 years. While our March 12th communication written in the midst of the breathtaking declines underscored our positive outlook, we were nevertheless impressed by the speed of the market’s rapid ascent.
In our view, the markets first underestimated the resilience of our economy and then over-reacted as end of the world scenarios proliferated. Our experience over the past forty years has taught us that the American economy, driven by entrepreneurial ingenuity, has surmounted a wide range of challenges. In this case, as business around the world ground to a virtual standstill, government transfer payments and Central Bank intervention first stabilized the markets. Then as the pandemic curve flattened, and business and social restrictions related to the virus were relaxed, economic activity resumed much more quickly than had been feared. The economy added 7.5 million jobs in May and June, reducing the unemployment rate to 11.1%. Government transfers pursuant to the CARES-ACT as well as higher unemployment insurance benefits, produced a nearly $3.0 trillion increase in personal income for the month of April, contributing to an 8% increase in personal consumption expenditures for May.
On the credit front, globally-coordinated monetary stimulus as well as unambiguous signaling from the Federal Reserve regarding additional measures to contain the economic fallout from the virus combined to keep both current rates and future rate expectations at historically low levels with 10-year treasuries ranging from 0.58 - 0.91%. These steps have dramatically improved liquidity in the corporate bond market with spreads normalizing throughout the quarter.
With respect to S&P 500® earnings, the economic recovery from first quarter lows has sown the seeds for a strong earnings recovery in 2021. We look for steady improvement in year-over-year earnings comparisons through Q4/20 and an acceleration into the new year. Earnings growth in 2021 is likely to approach 35%, to $160 with a further recovery to $185 - $190 in 2022. Based on these forecasts, the S&P 500 Index is trading at 19X and 16X CY2021 and CY2022 respectively, representing an earnings yield of 5.2% and 6.1% or 500 basis points higher than the current 10 year Treasury yield, well above the 150 bp historical average. In other words, the valuation on the market is not cheap absolutely but remains attractive as compared with investment alternatives.
Looking forward, we do not believe the March lows will be re-tested, but we do acknowledge potential headwinds that may contain the equity market at or near current levels. The most obvious negative is that Virus spikes may slow down or even flatten expected economic growth. We also think the market assumes we will have an available vaccine by early 2021. That may not be the case; it may take longer. Another potential negative is the impact of the 2020 presidential election cycle. The uncertainty of what a Democratic victory might mean for the market is probably not a positive. If any one or all of these factors seize investor attention we would not be surprised to see a 5-10% pullback, which in no way would derail our constructive, earnings based, 12-18 month target of 3800 for the S&P 500®, representing 22% upside from current levels.
Please give us a call if you would like to further discuss our market outlook or portfolio strategy.