Can the recent stock market rally be believed?
Imagine my 13-year-old asking me to help him with Zoom technology! My son has been virtually learning and his school has been doing an amazing job. On occasion, he has technical problems getting into a class and has asked for help. Why would he ask me? He knows that I am on video calls all day and so presumes I may be able to help. Two weeks ago my 87-year-old mother participated in a family Webex call from her smartphone, and last week she joined via her iPad!
We are adaptable creatures. We don’t always like it; however, we are.
We have been thinking about the current environment and how we must adapt our thought processes in the current and post-virus era. The No. 1 question from clients has to do with the recent equity market rally. Can it be believed? The fact is that stocks have rallied significantly — over 30% — based on the assistance provided to the economy, companies, and individuals by the federal government and the Federal Reserve.
To explore whether the rally “can be believed,” it is helpful to understand what has changed and what has not.
Household income has changed—but maybe not in the direction you’d assume. According to a study done by BlackRock, if unemployment peaks 20 percentage points higher than where we were before the pandemic, average household income drops by $30 per day. The stimulus put in place through the Families First, HCE, and CARES acts is equal to more than $2 trillion, or $86 per day in average household income. (These are averages and we recognize that not everyone has what they need to sustain themselves if they’ve lost income.) That’s an enormous number put to work in a short period of time. In fact, the study concludes that due to the stimulus, household income is actually 31% higher than it was before.
While reported as “stimulus,” these funds are better seen as a plug in the household income hole in the economy. The consumer still makes up almost 70% of the economy, so plugging the hole will help. We also know that consumers’ habits have and will change as the pandemic has required them to stay and/or work from home. Another change is that consumers have been saving more. The personal savings rate has spiked to almost 14%, a level not seen since the 1980s. Of course, this is partially a result of the safer-at-home orders. It is also a function of the uncertainty created by the virus. Individual investors’ conservatism can be seen in money market fund assets — currently over $4 trillion, which is more than $1.5 trillion higher than just a year and a half ago.
Like consumers, investors are adaptable creatures. Despite the high levels of uncertainty and staggering changes for the consumer and economy, they have taken government stimulus into account and responded favorably.
What hasn’t changed
Fundamentals matter. At the overall economy level, fundamentals include the pace at which the economy grows, the number of people working, and the rate at which their personal income grows. Fundamentals also include retail sales, energy usage, and the rate of inflation.
For equity investors, fundamentals refer to companies’ ability to grow earnings, generate free cash flow, and grow their revenues. Stock prices are nothing more than the present value of the future earnings a company generates after it pays its expenses and debt costs.
For bond investors, fundamentals refer to a company’s ability to pay interest and principal to its debtholder. Therefore, a focus is how much free cash flow are companies generating to pay those debts.
All of these fundamentals matter when thinking about the level of asset prices over time. And that’s just it — over how much time?
Well, that depends upon investor sentiment, which was horrible in the middle of March. But since then, markets have functioned more normally thanks to the Federal Reserve backstopping credit markets and investors looking further out into the future. Investors seek to look far beyond present circumstances. They think about all the things that might affect that future earnings stream — the pandemic, the government’s stimulus packages, the return to work, and the ability of the economy to recover.
We believe that when you take the stimulus into account and the more optimistic view of how the economy recovers and the pandemic fades, markets are likely appropriately priced. Of course, a more negative view could also play out. We need to take into account the less rosy scenarios and prepare for them by managing the investments we own, using prudent risk management and the rally we’ve experienced to our advantage.
What is certain is that we will continue to adapt. I have to go, my mother is FaceTiming me.
Brian Andrew is chief investment officer for Johnson Financial Group.
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