August 27, 2020
• After the unrelenting move higher over the past five months, the market is becoming stretched to the upside from a short-term perspective. However, we view the current backdrop as more akin to the extreme buying pressure that is often seen during the first stage of a bull market.

• History suggests record high stock prices alone should not be viewed as an investor concern. Since 1950, the S&P 500 has risen an additional 9.2% over the next twelve months after first trading to an all-time high.

• Absolute market valuations are expensive but are likely to stay that way given the lack of attractive investments elsewhere. The rule of 72, which is a simple way to estimate how long it will take an investment to double given a fixed annual rate of return, provides an eye-opening perspective.

• An important and underappreciated transition also appears to be underway—a move from valuations driving the market higher to one where earnings are now a significant contributor.

The Upward Momentum Continues

The S&P 500 trades at an all-time high. This feat would have been unfathomable back in March during the heart of the pandemic-induced selloff. Indeed, stocks have shifted from the fastest move into a bear market in history to an all-time high in record fashion. While this is far from a typical year, there are several factors that continue to support our view that we are indeed in a bull market.

After the unrelenting move higher over the past five months, it is fair to say the market is becoming stretched to the upside. One way to quantify this is to look at the market’s deviation from a longer-term trend, such as its average price over the past 200 days. Currently, the S&P 500 is more than 12% above its 200-day moving average (dma); on this metric, the market is slightly more extended above its trend than it was in mid-February, right before the market selloff began.  

However, we view the current backdrop as less comparable to February and more akin to the extreme buying pressure that tends to occur as a bear market transitions to the first stage of a bull market. A similar pattern to the current period is evident with the kickoffs to the 2003 and 2009 bull markets. That is stocks transitioned from extreme selling pressure to extreme buying pressure.

That said, the current V-shaped move makes the market vulnerable to bad news, and it would be normal for stocks to start to consolidate these sharp gains. We saw this occur in 2003 and 2009 after the market became extended above the 200-dma after the initial thrust higher. However, we still believe the primary market direction remains higher. That remains our focus.

Moreover, history suggests record high stock prices alone should not be viewed as an investor concern. Since 1950, the S&P 500 has risen an additional 9.2% over the next twelve months after first trading to an all-time high. This is roughly in line with the average performance of all periods studied during this time frame. This study is also consistent with stock gains moderating as we transition out of the first phase of the bull market, which tends to see the sharpest gains.

From a Valuation Expansion Story to an Earnings Recovery

From a fundamental perspective, another important and underappreciated transition appears to be underway—a move from valuations driving the market higher to one where earnings are now a significant contributor.

Since the March 23 price low, the majority of the market gains have been due to an expansion in valuations as the forward price-to-earnings (P/E) ratio for the S&P 500 jumped from 13x to almost 23x. Elevated P/Es are typical at troughs in an earnings cycle as the market starts to anticipate better profits ahead of the actual numbers improving.

However, since the early June valuation peak, which coincided with the blockbuster jobs report, the forward P/E has traded in a tight range of roughly 21.0x to 22.6x. Importantly, the forward S&P 500 earnings estimates bottomed in mid-May and have climbed more than 8% since then, supporting stock gains.

What may also be underappreciated by some investors is the likelihood that many of the surviving companies are set to come out on the other side of this crisis more efficient and more profitable than ever, aided by the acceleration of technology and productivity trends. Similarly, following the global financial crisis, corporate profits rebounded stronger than most investors expected, despite one of the weakest economic recoveries in history. Companies cut costs sharply, becoming more efficient, which led to a greater percentage of revenues flowing to the bottom line earnings number.

Applying the Rule of 72

We also expect stocks to maintain a premium valuation relative to historical averages given the lack of attractive investments available. The low interest rate environment is set to persist for the foreseeable future, pushing investors seeking higher returns into riskier assets.

An eye-opening depiction of the impact of this low rate environment can be seen through the rule of 72, which is a simple way to estimate how long it will take an investment to double given a fixed annual rate of return. (The calculation divides 72 by the assumed annual rate of return to estimate the number of years.)

Assuming what we view as a conservative 5% annualized return (below our long-term capital market assumptions), it would take an estimated 14 years for equity investors to double their money. It would take an estimated 103 years for an investment in a 10-year US Treasury note to double its investment value based on the current yield and 900 years for cash to do the same.

That said, equities also have much greater downside risks relative to cash and bonds, so it is not an apples-to-apples comparison from that standpoint, but these figures are still staggering.

Bottom Line

The weight of the evidence in our work still supports a positive longer-term market outlook. Stocks are arguably becoming stretched short term, but that is somewhat typical in the first stage of a bull market. Gains, almost by definition, have to moderate after such a sharp rise, and we fully expect the markets to have setbacks along the way. Stock valuations remain elevated but are likely to stay that way given the lower interest rate environment. We are also encouraged that the rise in the markets since June has been primarily driven by earnings. We also believe that the earnings power of the market may be underestimated coming out of this economic downturn, just like it was coming out of the global financial crisis.

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CN2020-1776 EXP12-2020