Reads on the economic data that August will bring could mark an inflection point for the currently roaring U.S. stock market -- and that inflection point could be positive or negative.
The S&P 500 is up 30% from its March 23 bear market low. Optimism that lockdowns will ease and head towards normalcy, and the view that fiscal and monetary stimulus will put a floor on the recession and aid a fast recovery has seen the market through almost to the other side.
The rise in stocks has been accompanied by a fall in the 10-year treasury yield to 0.59% from roughly 0.8%. And for some time, investors were piling into cash, sending the total amount of cash held by institutional investors to almost $3 trillion, up 30% from early February, according to data from the St. Louis Fed. These moves signal both that the rally has been liquidity-driven and that there has been some risk aversion alongside it.
The market is banking on a second half recovery, giving companies a pass on poor Q1 earnings and no guidance for the likely worse Q2.
And it has indeed been cyclical sectors driving gains. Stifel’s Head of Institutional Equity Strategy Barry Bannister wrote in a note that the 5 out of the 7 sectors in the S&P 500 that have outperformed are cyclical. Those include consumer discretionary and industrials.
"The rebound has been legitimate but is also fragile,” wrote RBC Capital Market’s Chief U.S. Equity Strategist Lori Calvasina in a note. "A second wave of infections and any evidence that the economy may continue to deteriorate beyond 2Q could cause stocks to turn lower quickly. A lack of visibility on earnings also seems likely to keep conditions choppy in coming months.”
Currently, stocks are pricing in a multiple of above 17 times 2021 earnings per share on the S&P 500 of $170, over 2020’s estimate of $135. Those analyst estimates are according to Yardeni Research. A normal multiple on 12-months earnings in a more certain environment can sit between 16 and 18 times.
Another way to understand this: low interest rates, making stocks more attractive have driven the equity risk premium to below 4%. That premium is the expected rate of return for a year in stocks minus the annual rate return on the 10-year treasury. The equity risk premium usually sits at around 3.5%, but stretched to 7% in March, making stocks more attractive. As investors bought up stocks, prices now only yield enough to bring the risk premium below 4%.
To Calvasina’s point about the market’s vulnerability, while many companies issued no guidance and ominous comments about Q2 in early April earnings reports, McDonald’s McDonald's has the misfortune of reporting later in the month.
McDonald’s (MCD) - Get Report reported Thursday and said the negative U.S. sales trends it started seeing in March would bleed into April. But the stock had already run up 11.5% for the month of April, so when the company offered nothing hopeful for investors, the stock fell by more than 2% Thursday, as it now trades at the more expensive end of its recent valuation range — it’s at 27 times next year’s earnings.
So you’re wondering what could bring stocks down again.
"We believe support for the S&P 500 price today likely requires a positive 3Q 2020 GDP inflection (i.e., bad data getting less bad) to reduce 2021 EPS risk, but we believe such visibility is still lacking and choose not to raise our S&P 500 target price,” Bannister wrote.
Simply put, if July rolls around and the market thinks August will show economic data remaining at or below its expected trough, stocks will fall apart. If investors see the trend towards moving back towards 0% GDP and then positive growth, the market will maintain its bullish posture.
Stifel also mentioned that a deflationary shock followed by “ever more” Fed stimulus would make him more bullish, he said
August is the month that needs to show economic data on trend to move positive, as both Bannister and Calvasina point out that, historically, the stock market bottoms about 4 months before the economic data bottoms in a recession.
The point: almost all sources TheStreet has consulted with say we’re in for a near-term pullback and that adding to stocks currently isn’t the safest idea. But the market is doing what it is doing for a reason and if it sees its thesis supported, it may remain put until earnings estimates catch up to prices.