As the U.S. makes progress on the vaccine rollout, our country’s economy is picking up momentum and slowly but steadily returning to normal. Pending any new setbacks, many large businesses are planning on bringing staff back to the office in September, and on the educational front, it appears schools at all levels are looking to reopen for the fall semester, and that momentum doesn’t look like it will be slowing down. Anecdotally, almost everyone we have spoken to over the past few months has told us that he or she is booking flights and getting his or her travel plans in place for the upcoming summer and fall. The main point: People are eager to return to as much normalcy as possible.
We’ve frequently mentioned that the markets have this innate ability to look forward six to twelve months. Whether it’s in anticipation of a recession or an economic expansion, the market has either sold off or recovered far in advance of the recession or economic recovery that later unfolded, and this time has been no different.
Let’s quickly summarize the market action throughout the past 15 months. We witnessed the fastest bull-to-bear market in history, from all-time highs on February 19, 2020, to the bottom on March 23, 2020, at the early stages of the pandemic that was immediately followed by the fastest bear-to-bull market reversal in history, from the bottom on March 23, 2020, to all-time highs less than five months later on August 18, 2020. Fast forward to today, just over a year later from the bear-market bottom, and most of the major market indexes are at or near new all-time highs.
We changed things up a bit with this update and decided to share five of the most-asked questions we’ve been receiving over the past few months and our insights on these topics.
1. What is driving the markets and the economy?
Technical trading. The S&P 500 Index, the Dow Jones Industrial Average (DJIA), and the Nasdaq Composite all set new highs in the first quarter, which has the computerized trading programs in a feeding frenzy, as these programs are set up to keep buying until the momentum breaks.
Helicopter money, free money! In the past year, the U.S. government has injected trillions into the economy and it is not done yet, as the new Biden administration is proposing to add trillions more via an infrastructure plan. Some of that money has gone into the hands that need the money, like people who have lost jobs or endured pay cuts, or into businesses that have been decimated by the virus’s impact on their respective industries. However, a large amount of this money has gone into hands that don’t need it, and that extra cash has inflated asset prices, stocks, commodities, housing, and, yes, even the prices of the various cryptocurrencies. This is the Economics 101 law of supply and demand in action.
Monetary policy. About 10 years ago, we coined the phrase, “low-interest rates are the gift that keeps on giving.” What we meant by that then was individuals, businesses, and governments were able to refinance debts at ultra-low rates, and that provided long-term benefits for the economy. Well, it’s happening again now at even lower interest rates. In terms of mortgages, I’ve seen 30-year mortgages at 2.5%, 15-year mortgages at 2%, and 10-year mortgages at 1.75%. With a limited housing supply and low mortgage rates, it’s not hard to understand why we are witnessing bidding wars on housing across the country. We now have generations of households that are benefiting from inflation-protected home-ownership costs that are substantially lower than the non-inflation-protected cost of renting. That benefit will continue to filter into the economy, especially when we all start traveling again and feel comfortable spending money on traditional forms of entertainment.
A strong consumer. Consumer spending contributes almost 70% of the total U.S. production, meaning a healthy consumer is critical for the U.S. economy. The household debt service ratio as measured by debt payments as a percent of disposable personal income is at a 40-year low. Unsurprisingly, this is a result of helicopter money and cheap borrowing costs.
2. Should we be concerned about the national debt?
The reality: The pandemic-era stimulus is expected to push the national debt to $35 trillion by 2023. Treasury Secretary Janet Yellen has been urging global finance leaders that, “the time to go big is now,” citing lessons learned from the 2007-2009 financial crisis, and the U.S. is definitely heeding her advice. The federal debt ballooned to a record $28.1 trillion as of March, up significantly from the $23.2 trillion at the start of the pandemic, and further pandemic relief measures plus President Biden’s infrastructure push will only augment that total. It’s easy to rack up debt when the U.S. remains the world’s reserve currency.
While it’s easy to rack up the debt, at some point we have to answer the question that keeps getting swept under the rug: How much debt is too much? For now, and for the intermediate-term future, no one is seeming to worry about our abilities to service the debt citing today’s low-interest-rate environment. It’s simple; our government is receiving the same benefit from the low-interest-rate environment as we do when refinancing our higher-rate debts into a lower-rate debt (e.g. our mortgages). However, what happens when the U.S. government is faced with measurably higher borrowing costs? The answer: I don’t know, and that makes me feel uncomfortable when thinking long-term. That being said, the swelling national debt will continue to be an indicator to keep an eye on.
3. Should investors be concerned about valuations?
Yes, especially after a long market rally like we have experienced over the last 12 months. So, how do today’s valuations compare to average valuations over the last 25 years? A popular measure for valuations is the forward P/E ratio (price-to-earnings) of a company or market index. The higher the forward P/E ratio, the more expensive a stock or a market index is, and vice versa. As of March 31, 2021, the forward P/E ratio of the S&P 500 Index is 21.9, which is above the 25-year average of 16.6, but nowhere near the 27.2 registered at the peak of the tech bubble on March 24, 2000.
How high are the valuations of the market darlings? As of March 31, 2021, the P/E ratio of the 10 largest stocks in the S&P 500 is 30.1, which is a 54% premium over their average valuation (19.5) of the last 25 years. What’s interesting is the remaining 494 companies in the S&P 500 Index (there are currently more than 500 companies in the index) were trading at a forward P/E of 19.6 as of March 31, which is “only” a 26% premium over their average (15.6) of the last 25 years. With that in mind, is there a justification for the premium being paid for the 10 largest stocks? Possibly. Over the last 12 months, the earnings contribution of the top 10 amounted to 26.7% of the profits earned by all of the stocks in the index, and their respective revenue and earnings are growing at a faster pace than their peers. Investors have been paying up for a higher quality earnings stream.
Why are valuations higher today compared to the 25-year average? Many market strategists believe higher valuations are justified in today’s low-interest-rate environment because the yields available for safe-haven investments remain relatively low, meaning investors are not running to these securities – which historically has occurred during times of perceived economic turmoil – yet. That being said, we believe valuations should be higher than the 25-year average due to today’s low-interest-rate environment. In other words, a company’s or a market’s earnings should be valued higher today compared to periods with higher interest rates.
4. How will the proposed tax increases affect the market?
First, we need to distinguish between individual taxes and corporate taxes. We don’t think modestly higher individual tax rates on taxpayers earning above $400,000 will have a measurable impact on the economy, but we do believe the proposed 28% rate for corporations will adversely affect the markets. It’s actually fairly simple: Higher corporate taxes will reduce net earnings, just as the lower tax rates implemented in 2018 increased the profitability of companies. We are hoping that wiser heads will prevail, and the parties will compromise and, in the worst-case scenario, implement a modest tax increase for corporations.
5. What else is on our minds?
Investor complacency! We hate it when investors think the market only goes up! Since hitting a bear-market bottom last year on March 23, 2020, the three major U.S. indexes – the NASDAQ, the S&P 500, and the DJIA – have been full steam ahead with virtually no bumps in the road. Although these gains have been great for the Wall Street optimist, this surge in stocks is not sustainable, and a mild-to-moderate correction is needed to keep valuations and euphoria at bay for the health of the long-term markets.
We’d be remiss by not mentioning a possibility that is on many of our minds: What if this pandemic takes a turn for the worse with the virus mutations? The spread of more variants of COVID-19 could slow economic recovery; however, earlier this month, the International Monetary Fund (IMF) still upgraded its global economic growth forecast for the second time in three months. We have weathered the challenges of this past year; if the pandemic takes a deeper dive for the worse, the economy and markets should be able to hold their ground with a few inevitable dips and bumps along the way.
The recovery has continued to gather momentum as vaccine availability and distribution has increased, and in light of this, economic fundamentals and the markets have gotten off to a good start this year. The market broadened, benefiting all investors; however, as we stated above, this yielded the investor who views the current market environment as devoid of risk, and that is worrisome. Last Friday (April 23), the S&P 500 closed just shy (0.33% to be exact) of an all-time high, and how this week pans out depends on how earnings unfold, as this is the biggest week of the earnings season that will include reports from the largest companies in the S&P 500. We are currently within the 72 hours that are arguably the most important of the year, as the big tech companies – Microsoft, Alphabet, Facebook, Apple, and Amazon, to name a few – update first-quarter earnings, while the Federal Reserve has its policy meeting that is expected to focus on the faster inflation signals amid a roaring domestic economy. By next week, we’ll have a fuller picture of what we could see unfold in the second quarter, and although the first quarter momentum seems likely to carry through, it is prudent to remember that a healthy and needed correction may be on the horizon.