The S&P 500 stock index dropped in September but finished up 8.5% for the third quarter. The advances built on even bigger gains in the previous period, capping the best two-quarter performance since 2009. While the market cap-weighted index is now positive for the year, it has truly been a bifurcated market with the technology sector and the consumer discretionary sector up over 20% year-to-date while the financial and energy sectors are down 22% and 50%, respectively.
Many investors attribute the broader stock market’s strong performance to an economy that has steadily improved, though it remains far from where it was to start the year. Consumer spending has ticked up from abysmal levels earlier in the year, the housing market is strong, and hiring in the U.S. has picked up for four consecutive months.
With data in the United States better than expected, the Fed now sees the economy shrinking 3.7% in 2020, far less than the 6.5% decline it forecast in June. Nevertheless, Fed Chair Jerome Powell said the central bank is planning to keep its foot on the monetary gas pedal for years. The Fed vowed to keep interest rates near zero until inflation is on track to overshoot its 2% target. Fiscal stimulus is expiring, however, and Congress is currently in a stalemate over a new bill.
The stock market is looking past dismal 2020 earnings (S&P 500 operating earnings are expected to decline 19%) and is anticipating a 26% rebound in 2021 operating earnings. The third quarter earnings reports and future guidance from company managements over the coming weeks will thus be critical to future market moves. Stocks are certainly not cheap as evidenced by the 23.4 multiple on trailing earnings and 22.2 multiple on forward earnings. The inverse of the price/earnings ratio is the earnings yield which stands at 4.2%. While this has historically closely tracked the yield on the 10-year Treasury note, the current 10-year yield is a paltry 0.7%. This gap implies stocks are relatively more attractive than bonds although the gap could be closed by lower than expected earnings or rising interest rates or both.
There are plenty of other potential challenges ahead for investors. We’ve heard there is a presidential election in November, and the election results may not be known immediately (or ultimately be decided in the courts). No matter who wins the election, taxes are likely to increase as federal debt and the deficits have skyrocketed. The coronavirus obviously remains with us and its effects are causing massive lay-offs in the airline and other industries. Many small businesses have or will permanently close, and bankruptcy filings have spiked. The timing of widespread distribution of a viable vaccine and advances in therapeutics remains unknown. The big technology stocks which have led the market are under scrutiny by the government. Indeed, the Wall Street Journal reports that the House Antitrust Subcommittee is almost done with its nearly 15-month investigation into the power of Google, Apple, Amazon and Facebook, and Democratic lawmakers seem poised to call for aggressive action against technology companies. The market abhors uncertainty.
In the midst of these uncertainties, there are companies which have rock-solid balance sheets, have high profit margins, continue to generate strong free cash flow, and return a portion of the cash flow to investors. These are the companies we want to own - when their stock prices are selling for reasonable multiples.
The LVM Team