FINANCIAL MARKET UPDATE 7.14.2020

AUTHOR: JOSH JENKINS, CFA

STORY OF THE WEEK

SOME STOCKS LOOK EXPENSIVE BASED ON POPULAR METRIC

The blistering market recovery that began in late March has cooled recently. The S&P 500 has gone nowhere in the last seven weeks, mostly trading in a narrow range between 3,000 and 3,200. Among the headwinds against further gains might be elevated valuations. At the start of the third quarter, the S&P 500 was sporting a price-to-earnings ratio (P/E) of 22.7, the highest level since January of 2018.

Source: Morningstar direct, data from Dec 2001 through June 2020. 

The P/E ratio provides a simple tool for understanding how cheap or expensive the stock market is at a given time. Interpret the measure as the price that must be paid for a dollar of earnings. Generally speaking, the lower the price paid, the better the potential return. Based on the chart above, investors have rarely paid more over the last (nearly) twenty years. Return expectations should, therefore, be tempered.

There are some drawbacks to the P/E ratio. Although it typically does a good job of setting expectations for long-term returns, it can be very noisy in the short-term. Expensive stocks can stay expensive (or get more so) for an extended period of time. Additionally, the business cycle can cause distortions. During periods of economic weakness, a decline in earnings could cause the ratio to rise even with lower stock prices. Despite these shortcomings, I believe the P/E ratio is a useful tool for setting expectations. Above-average P/E ratios typically result in below-average returns in the long-run, and vice-versa.

As companies begin reporting results for the second quarter this week, the market is trading near positive territory year-to-date. To justify more gains, it would be helpful if earnings results were better than expected. There are a couple of reasons this might happen:

  1. There is a widely known pattern where companies guide expectations lower ahead of time and then easily outperform those lowered expectations. As of 3/31/20, S&P 500 earnings were expected to decline by -13.6% year-over-year according to Factset. By 6/30/20, that estimate was lowered to -44.6% (Factset). 
  2. As the quarter progressed, economic data began to surprise to the upside. The better than expected performance of the economy did not translate into material increases to forecasted business results.

While a strong earnings season relative to expectations could be a tailwind for the market, there are still a few headwinds. Most notably, the recent resurgence in the spread of Covid-19 has caused some states to pause and even reverse the reopening process. Meanwhile, some fiscal stimulus measures that have supported households and the economy are set to expire later in July. Finally, if the market is already expecting companies to beat expectations handily, it may already be baked into prices, which would lead to an elevated P/E. Over time, there is a gravitational pull on the ratio to its average level. If it is elevated, it can move back in-line with either rising earnings or falling prices. As a result, anything short of handily beating the analyst’s forecasts could be met with a sell-off.

It is definitely possible the S&P 500 resumes its trek higher, but with an elevated P/E ratio, the bar has been raised. Although the large stocks of the S&P 500 look expensive, other areas of the US market do not. Small-cap value stocks, like those of the S&P 600 value index, actually look very cheap in comparison. Unlike their larger counterparts, these out of favor companies don’t necessarily need strong growth to justify their prices. While cheap stocks can stay cheap for an extended period of time (or become more so), their lower than average P/E ratio suggests better times are ahead.

Source: Morningstar direct, data from Dec 2001 through June 2020. 

WEEK IN REVIEW

  • Data published this morning showed consumer inflation rebounded slightly in June (.6% YoY), after declining on a YoY basis every month since February. The core CPI figure, which strips out the volatile food and energy categories, increased 1.2% YOY, which followed three consecutive declines. Despite June’s increase, both measures remain well below pre-COVID levels. There are some fears that the unprecedented levels of fiscal and monetary stimulus could cause excessive inflation. Counterpoints include the fact that the Fed has failed to move inflation higher for years, and now there is significant slack in the economy.
  • Yesterday the governor of California, Gavin Newsom, expanded the list of businesses that have been ordered closed. The most densely populated areas had already seen bans on bars and indoor dining, but that order now covers the entire state. Additionally, other indoor businesses have been shut down in highly populated areas.
  • Additional data to watch out for this week include industrial production on Wednesday and initial jobless claims and retail sales on Thursday.

HOT READS

Markets

  • Tesla Gives Up 16% Pop to Close Negative in Wild Speculative Trading (CNBC)
  • California Closes Indoor Restaurants, Movie Theaters and all Bars Statewide as Coronavirus Cases Rise (CNBC)
  • U.S. Consumer Prices Rose Sharply as Reopenings Prompted More Buying (WSJ)

Investing

  • Not Crazy Can Still Be Nuts (Irrelevant Investor) Comparing Today’s Tech Rally vs the Dot Com Bubble
  • Lots of Things Happening at Once (Collaborative Fund) Big trends rarely have just one cause

Other

  • Quit Chrome. Safari and Edge Are Just Better Browsers for You and Your Computer (WSJ)
  • How Tech Giants Make Their Billions (Visual Capitalist)

MARKETS AT A GLANCE

Source: Morningstar Direct.

Source: Morningstar Direct.

Source: Treasury.gov

Source: Treasury.gov

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

ECONOMIC CALENDAR

Source: MarketWatch

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ABOUT THE AUTHOR

402.763.2967

jjenkins@lutz.us

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JOSH JENKINS, CFA + SENIOR PORTFOLIO MANAGER & HEAD OF RESEARCH

Josh Jenkins is a Senior Portfolio Manager & Head of Research at Lutz Financial with over nine years of investment experience. He is responsible for assisting clients in the construction, selection, and risk assessment of their investment portfolios. In addition, Josh will provide on-going research and trade support.

AREAS OF FOCUS
  • Asset Allocation & Portfolio Management
  • Investment & Market Research
  • Trading
AFFILIATIONS AND CREDENTIALS
  • Chartered Financial Analyst (CFA)
  • Chartered Financial Analyst Institute, Member
  • Chartered Financial Analyst Society of Nebraska, Member
EDUCATIONAL BACKGROUND
  • BSBA, University of Nebraska, Lincoln, NE

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