As our lives have all been upended due to COVID-19, with an extreme drop in value and subsequent rally in the stock market, many are wondering where we are now. Is it overvalued? Undervalued? Will we test a new bottom?
The Stock Market is a Leading Indicator
Some may wonder – with death numbers increasing and uncertainty everywhere, why did the stock market go on a huge run the last week? The answer could be multifaceted, but one of the main reasons was because the death toll numbers were being adjusted downwards and the data is pointing towards more optimistic projections of ICU bed usage and critical cases. If we extrapolate that onto the projected “opening” of the economy, it appears that the more extreme measures we have been asked to take in regards to social distancing and staying at home are likely to be relaxed within the next 4-6 weeks. This has led to some positive momentum in the price of stocks.
Valuation of Stocks
If we look at the stock market price to earnings ratio (P/E), we will find that presently it is at about 17.6 (using SPLG as a benchmark). This is slightly above the historical average of 16 or so, but over the last five years, we have been running at a P/E in the low 20s.
S&P 500 P/E Ratio, Last 5 Years
When either the numerator or denominator gets way out of whack, you can see the P/E spike, having the appearance of overvaluation. This can be a false flag, as seen by this chart showing P/E ratios after the 2008 crash. This event could occur again shortly, as earnings are about to get crushed by the freeze in economic activity.
S&P 500 Historical P/E Chart
So what does this mean about valuations and the present stock market? It’s uncertain to be sure. If the virus doggedly hangs on and the policy by the state governors and the Trump administration is one of extreme caution, it is highly likely that the economy will take longer to recover. Another plausible scenario is that the economy gets opened up only to be shut down again after a return of momentum in COVID-19 cases. In either regard (and of course there are many other possibilities), the recent stock market rebound is pricing in a fairly rapid rebound in profits after the likely recession we will have in quarters 2 and 3. If this does not occur, it is very possible that stocks are overvalued at this time and we may see another significant pullback (or two) before recovering.
How Does Governmental Action Through the CARES Act and Federal Reserve Impact Economic Conditions?
What we have seen from the government in this crisis has been absolutely unprecedented. To compare and contrast the 2008 efforts with current action, here is a good article to read. There has been a massive effort to keep Americans on payroll and extend unemployment benefits to workers that previously did not qualify (like “gig” workers or freelancers). Furthermore, direct stimulus payments were sent to Americans that qualified and small businesses were allowed to participate in a variety of loan programs, some of which will offer loan forgiveness. Obviously this will eventually lead to long-term ramifications for our economy, many of which are unknown at this time. At a minimum, we will have incredibly high deficits in 2020 and likely beyond. This may lead to higher interest rates through borrowing costs, as well as increased unemployment insurance premiums for companies, a potential for inflation, and higher tax rates for both individuals and corporations.
What Does That All Mean and What Should I Do?
The best analogy I heard recently was that the economy is like a muscle. If you do nothing to your body but sit, your muscles will atrophy. The longer your muscles are allowed to be dormant, the longer it will take to get them back into shape. If allowed to go too long, those muscles may never recover, and even if it is relatively short term, some lasting damage could still be done. While it is likely not responsible for us to just open up the floodgates to accept an increase in virus count, there also will be a balance point where opening the economy to allow for goods and services to be consumed more freely makes sense.
So….what to do? Continue to look at the data. There’s tons of great sources, including Worldometer, COVID-19.direct, and IHME. Practice social distancing, be safe, and start to make a plan for how you are going to handle your financial and personal life after we are allowed to return to our places of business, coffee shops, and recreational areas. Get out for frequent exercise and fresh air (we just found out that BMI is a significant factor in being hospitalized in coronavirus cases), and enjoy the responsibilities of being a teacher or simply just enjoy being a Zoom meeting happy hour participant. Whether the stock market goes straight up from here or it tests a new bottom, this too shall pass.
Disclosure: The post was written in a rapidly changing environment for the stock market. You should not treat any of this commentary as investment advice. Please work with a professional advisor to discuss your own personal financial situation. Charts were presented as illustrative in nature only.