Let’s look at fundamentals versus what’s actually going to happen in the near-term.
Many on Wall Street admit that stocks look fundamentally challenged. And yet, many of those who agree with that assertion have bought some stocks after the U.S.’ bear market low on March 23.
Here’s how this all breaks down.
First off, yes, the S&P 500 will end the week down about 6%, but the index is up about 34% since March 23. And that move hasn’t been all about investors moving into growth tech stocks (FAANGs, 5G-exposed chip stocks, cloud stocks and cloud-exposed chip stocks) because they are unenthusiastic about economic growth. Value and cyclicals have turned upwards significantly. The Vanguard S&P 500 Value (VOOV) - Get Vanguard S&P 500 Value ETF Report, albeit an underperformer, is up 30% since March 23, which is no small gain.
But most investors haven’t really poured into stocks unabashedly — certainly not recently.
Investors are well aware of the risks: a second wave of virus infections, which is already taking hold and damaging market sentiment this week, a slower-than-expected recovery from the recession and the end of free-trade between the U.S. and China. Meanwhile, the equity risk premium — the excess rate of earnings return on stocks for a the next year compared to the interest rate on the 10-Year Treasury bond — sits at around 3.4%, slightly low. Historically, that premium return sits at around 3.5% for a healthy economic environment, which we may not be in currently.
Some have said the roughly 24 times forward earnings valuation on the S&P 500 is exorbitant, but it’s actually not crazy compared to interest rates. The valuation may be stretched if the reality is that the risk premium over interest rates should be higher because the economic fundamentals are weaker than perceived. Simply put, stock prices may be too high.
As that premium return was dwindling in April’s big rally and as the stock gains continued in the second half of May, many fund managers were telling TheStreet that they were adding to stocks incrementally; they were marginal net buyers of stocks. They wanted protection against upside risk but still held onto a lot of cash so they could be ready for a correction.
“Over the past couple of weeks I’ve made the argument that we’re not seeing sellers emerge right now,” John Ham, Associate Adviser at New England Investments and Retirement told TheStreet. "Everybody is going in the same direction. Everybody is a buyer. It takes a lot of people rowing in one direction to get outcomes like that [up moves].”
And for further proof that investors are really and truly staying away from an aggressive portfolio tilt, Bank of America Global Research wrote in a note that the firm’s average private client currently holds about 58% of total assets in stocks. The boiler plate diversified portfolio is 60% stocks, 40% safer assets.
And Ham said the average client at his firm is a bit under the standard 60/40 allocation and positioned “defensively.”
These trends indicate that, with still a lot of cash on the sidelines, stocks have further room to run if investors have any interest in becoming fully invested.
One reason investors have been comfortable taking on incrementally more risk even with stretched valuations is because of that mountain of cash held (institutional investors holding over $3 trillion of cash, up 39% since early February: St. Louis Fed data). They’re already protected. And they can’t move into treasuries because those offer almost nothing over inflation.
There’s an expression in markets that goes: “there is no alternative,” or “TINA.”
That should only hold true if interest rates are so low that stock prices must rise to a fair valuation by historical standards. But the reality is that investors are willing to be cavalier about valuations if there is really no alternative to stocks. The equity risk premium dipped to 2.99% last week before investors got real about the virus this week. Money was being “forced” into the market, Ham said.
Stocks may continue to rise as most market participants currently have marginally strong risk appetite.
But if lockdowns are reinstated, that could simply force investors into even more of a fear trade than we saw this week. Looking at fundamental value, Stifel’s Head of Institutional Equity Strategy, Barry Bannister wrote in a note "As speculative froth created by excess liquidity peaks and fundamental analysis returns we switch to Equity Risk Premium for S&P 500 price targets,” as he lowered his year-end S&P 500 price target to $3,100, representing just 3% upside from here.