Markets Have Begun to Price in That Economic Recovery Again

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The prices of financial assets the past month have been behaving in a way that suggests a high degree of optimism in the continued economic recovery from the coronavirus pandemic.

Let’s get right into the analysis.

Since September 23, the S&P 500 is up 6.8%. That may not sound so incredible, but it’s a large gain for one month. If an investment were to compound at that rate per month for an entire year, the price return would be above 100%. Stock markets don’t rise by that magnitude over one-year periods. It’s not that we haven’t seen this kind of gain in a one-month stretch ever, but we are coming off of a September sell-off that preceded renewed optimism over virus vaccines and strong economic data.

In September, large cap value stocks, largely well correlated to changes in the economy, fell almost 10%, while large cap growth stocks fell about 13%.

Since September 23, large cap value rose. The Vanguard S&P 500 Value ETF  (VOOV) - Get Report, trading at $112 a share, is close to its post-lockdown high of $115, which it hit on June 8. That was the date of peak optimism on the speed of the economic recovery. That day, Wall Street was expecting the Bureau of Labor Statistics to report a net loss of jobs for a recent time period of a few million workers, but the number was a gain of more than 2 million.

And on June 8, the 10-Year Treasury yield, which had bottomed in March at 0.55%, hit a post-lockdown high of 0.9%. Since September 23, the yield has risen from 0.67% to 0.84% Friday. Investors are pricing continued inflation, which the Federal Reserve is aggressively looking to bring to an average of 2% over time by buying treasuries and easing the cost of borrowing.

The higher yields recently are a positive indicator for stocks because they indicates confidence in the economic recovery. Recently, the recovery has slowed as Congress has been unable to pass the all-important fiscal stimulus bill. But investors expect heavy fiscal spending if Vice President Joe Biden wins the election -- and his lead in the polls is still commanding even after falling a bit after Thursday’s debate. Plus, Moderna  (MRNA) - Get Report is nearing emergency use authorization for its vaccine, which is currently in phase 3 of trials. If you’re looking for an indication that investors are confident a vaccine will soon hit the market, Moderna is up 29% since September 23.

But the higher treasury yields also make stocks incrementally less attractive. Higher bond yields increase the cost of capital for companies and make the excess return expected on stocks incrementally less attractive. The S&P 500 is actually down a bit since October 12, when treasury yields began seeing their most recent leg higher. Since then, large cap growth stocks, as seen on the Nasdaq 100, are down 3.6%, while value stocks are down just 0.8%. Higher interest rates indicate inflation, which cyclical stocks like industrials and consumer discretionary can benefit from. Growth tech relies on the secular expansion of new services like e-commerce, cloud, and streaming, leaving those stocks to only see the negative of higher interest rates.

Earnings have also been a part of the optimism. Companies sensitive to reopenings and economic demand are beating revenue estimates. That includes Southwest Airlines  (LUV) - Get Report, which said it is seeing month-over-month demand improvements and Coca-Cola  (KO) - Get Report which said the same. Coke is less demand sensitive, but its easing year-over-year volume declines shows that people are returning to restaurants, which comprise a solid chunk of the company’s revenue. Earnings on the S&P 500 are expected to decline year-over-year, but the aggregate decline may come in at a lower rate than forecast, another signal that 2021 could show earnings at pre-pandemic levels.

Also, while questions over the speed of the labor market recovery have emerged, the full picture shows an incredibly fast recovery. Within months, the unemployment rate has fallen to 7.9% from 15%. Loan delinquencies, which are historically correlated with employment, have fallen to below 4% from about 4.5%, according to Principal Global Insights. Banks, which are showing drastic improvements in credit quality (a positive for earnings because they then set aside less cash for bad loans) and benefiting from an expanding yield curve, are up about 12% since September 23.

The recently strong earnings and labor market data are backward looking. The market has slowed down in the past week or so, as the continued economic recovery hinges on vaccines and stimulus, both of which remain unknowns to some extent.

One of the major factors underpinning the recent investor optimism in the continued recovery is the cash built up in the economy. Even if there is a delay on fiscal stimulus, consumers have cash ready to be spent. Total cash sitting in bank deposits in the U.S. is almost $6 trillion, according to data from Morgan Stanley global strategists. That’s about 26% of GDP, the strategists say. Monetary and fiscal stimulus has played a huge role in the cash build-up.

Just before the pandemic bank deposit cash was about 18% of GDP at around $4 trillion. And during peak fear during the financial crisis of 2008, cash as deposits was about $1.6 trillion, or about 17% of GDP. When the economy reopens, consumer could start dropping cash on all sorts of experiences and products, which would be a major tailwind for consumer discretionary stocks, the large caps of which are up about 9.5% since September 23. An equal-weighted index tracking those stocks has a price of 3,881, a touch higher than the 3,591-level hit June 8.

“You’re going to see an economy explode higher with the unleashing of pent up demand based on a surge of confidence, and oh by the way, you still have all this monetary and fiscal stimulus,” Hank Smith, head of investment strategy at Haverford Trust ($9 billion in assets under management) told TheStreet. "In anticipation of that, you will have potential for real returns in value [stocks].”

The last point here: credit spreads.

Since September 25 high yield spreads in the U.S. have come down from 5.6% to 4.8%, according to data from the St. Louis Fed. That’s no surprise as treasury yields have come up a bit, but high yield bond prices have also risen, with the iShares iBoxx High Yield Corporate Bond ETF up 2.2% since September 25. For reference, the spread was still above 5% June 8. This just means bond investors are accepting a lower yield when compared with the safest bonds on the market because they perceive less credit and profit risk in the companies they are giving credit to.

So, there you have it. Now, there’s serious risk to the market if things don’t work out too well in the coming months, but markets are often right. Take your cues. And follow the vaccine and stimulus news.

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