Stocks had a stellar week, as risk sentiment firmed and the market continues to look past an ugly 2020. But three risks, colliding with stretched valuations are leaving the market vulnerable.
For the week, the S&P 500 rise over 3%, bringing its gain since its March 23 Bear market low to roughly 30%.
While it’s true that big tech — Facebook (FB) - Get Report, Apple (AAPL) - Get Report, Amazon (AMZN) - Get Report, Netflix (NFLX) - Get Report, Google (GOOGL) - Get Report and Microsoft (MSFT) - Get Report have all outperformed in the past month — cyclical value stocks have as well. Investors like to pile into big tech, which can largely elude recession and maintain strong revenue and earnings growth with their secular industry trends. But when cyclical value gets a boost, it can often be a sign that investor sentiment is strengthening.
This past week, cyclical sectors which encapsulate many value stocks, have performed with notable strength. The S&P 500 equal-weight consumer discretionary index rose 2.6%, with the Nasdaq Industrials Index up 5.2%, The Dow Jones basic U.S. materials Index up 4% and the SPDR Energy ETF (XLE) - Get Report up more than 6%.
State re-openings, trade tensions easing and fiscal and monetary stimulus aiding consumer spend are all enabling investors to perceive a sharp economic recovery. Companies across sectors, from Chipotle (CMG) - Get Report in food, to Facebook in ads and tech to Uber (UBER) - Get Report in ride-sharing have all said on their earnings reports that they are seeing spending decline at a less severe rate in the past few weeks.
But the move into stocks has been accompanied by a move into cash, as treasury prices are elevated partly due to the Federal Reserve's stimulus program. Global cash holdings are near $5 trillion, according to data from the St. Louis Fed, up roughly 60% just since April 13 and at their highest levels ever.
While sentiment is overall strong, money managers TheStreet has spoken with have said they’ve been marginal net buyers of stocks in April but are growing tepid on adding more in the near-term.
With interest rates lower than at pre-virus levels, the S&P 500’s multiple on 2020 earnings is 22.5 times, high historically. The multiple on 2021 earnings is 17.5, a slightly rich multiple on just forward one year earnings, historically.
This leaves the three biggest risks out there as particularly potent, should one come to fruition.
Reinfections and Re-openings
States could be reopening too soon and many on Wall Street have been quick to point that out.
"You’ve had a lot of people in the medical arena say that there are potential risk as we reopen, that more people are going to be exposed [to the virus],” Tony Bedikian, Head of Capital Markets at Citizens Financial told TheStreet. "That’s going to be a risk as we move further into the year, that the virus data is really ultimately going to be what dictates further direction for the market. The market seems to be pretty optimistic about how the virus us going to play out.”
Strategists at Stifel and RBC Capital Markets have recently pointed out that stocks tend to bottom roughly 4 months before economic data bottoms in a recession, making August a pivotal month for the market to see if the economy will truly trough at that point. But if quarantines come back and states shut down again, “Absolutely it’s a possibility” that the recession lasts longer than expected, Bedikian said.
Pace of Economic Recovery
That brings us to this next risk.
With the S&P 500 just 14.5% below its all-time high, after having fallen 34% below that level in March, most agree the market is pricing in between a V-shaped and U-shaped economic recovery, while many begin to warn of a U-shaped or W-shaped recovery.
This leaves the market to either remain range-bound for an extended period while forward earnings estimates catch up to prices or to fall to reflect near-term expectations.
This may be a hidden risk almost no investor appreciates.
"2020 vs 2021: pandemic and recession means policy makers [are] forcing investors to buy, banks to lend, corporate zombies to issue in 2020; but in 2021 policy makers [are] to demand payback via taxes, regulation, Wall Street and Silicon valley wealth; we stay structurally bearish,” wrote strategist at Bank of America Global Research in a note.
The government has spent trillions of dollars — and a record amount — on fiscal stimulus. The treasury department is issuing tens of billions of dollars of treasuries to fund the stimulus (putting near-term pressure on treasury prices).
A higher tax regime may be in the cards for 2021 so the government can recoup lost revenue. States are in need of cash as well and may need upped allocations from the federal government.
Higher corporate taxes would hurt earnings and be immediately priced into stocks, negatively. Higher personal taxes would have a negative impact on consumer spending, denting revenue growth.
If Democratic candidate Senator Joe Biden wins the election, he may bring about a more progressive regime. While the fear that the market-unfriendly Senator Sanders wins is gone, Biden may not exactly be fiscally conservative.
A higher tax regime in 2021 would likely begin to cause market unrest well before 2021, so even if virus-related risks fade, the tax risk is another hill to climb for stocks in 2020.