Too good to be true?

Since the dramatic lows of March, the markets had been making a remarkable recovery before hitting a rocky period last week. Was the revival simply too good to be true? Our Head of Research, Guy Foster, explains what has been happening.

Only a few weeks ago investors were worrying about how long a recovery might take; few would have predicted that in the second week of June the S&P500 would have moved positive for the year. Falls in the following week however, including the markets’ worst day since March, have punctured any (over)confidence there might have been. Nonetheless, considering what we saw in March, the overall picture is worth noting.

What has been surprising to many is that the markets have been able to perform remarkably well at a time when the economic data we are seeing is remarkably bad. The historic pattern for periods of high volatility sees a dramatic downturn followed by a short rally, before seeing another drop. This time the markets have not followed that pattern.

Markets v the economy
That is not to say that the market’s performance is difficult to understand.

The relevance of the economy to the market is its relationship with profits. Both will now be depressed by the Covid challenge. But the companies which make up the market are valued not based solely upon this year’s profits, but on all those they stand to make in the future.

Opportunities often come in the world of investing when investors unfairly project temporary weakness into the long term. Certain investor norms encourage this. The most popular and crudest measure of the value of stocks is the price earnings ratio. This is the share price divided by the profits accruing to a single share. It is an approximation at best, struggling to take account of how much those profits are likely to grow (or not). But the price to earnings ratio certainly only works if the denominator is a reasonable reflection of ‘normal’ earnings power of the company. While they are depressed by lockdown it will be misleading.

So what does Covid mean for earnings growth? It obviously depends upon the business in question. At the risk of generalising: for e-retailers and those supporting agile working etc it can be assumed to have brought forward growth from the future; for airlines and cruise operators earnings growth may be structurally impaired; but, for a lot of companies the most likely prognosis is that the decline in earnings is temporary. And for them a modest fall is more appropriate than a large fall.

From another perspective, sentiment was very depressed when the crisis first hit; we had a substantial stimulus and now the outlook for non-equity savings vehicles (bonds, cash) has deteriorated. When markets rise amidst a lot of investor scepticism, they can gather pace quickly. Investors who are underweight equities, or speculators who have bet that markets will fall, will feel pain and more likely than not be squeezed into buying.

Investors sometimes refer to this phenomenon, whereby the market seemingly moves in a way which catches out the greatest possible number of investors, as the pain trade.

What next?
There were, and are, risks. We have always maintained that the passage of time, and resulting decrease in uncertainty, will help this market to recover. That may not be an entirely smooth journey.
Since the dramatic lows of March, the markets had been making a remarkable recovery before hitting a rocky period last week. Was the revival simply too good to be true? Our Head of Research, Guy Foster, explains what has been happening.

Infection rates have generally come down as expected. But in some regions, they are proving more stubborn and the increasingly relaxed attitude towards lockdowns threatens a resurgence. The absence of a second wave in May had been a major boon to the market but rising hospitalisation rates in the southern states of the US and some sporadic outbreaks in some of Europe are reminding investors and policy makers not to become complacent. A sudden outbreak in Beijing has also shown that the virus can begin spreading again in the sterile atmosphere of a totalitarian regime as well as the fertile petri dish of democracy.

There remains plenty to be concerned about. We are now facing a second wave of sorts and if lockdowns
were to need to be extended en masse, then the risk is that policymakers begin to question whether the cost of maintaining stimulus until recovery comes is becoming intolerable.

More stimulus
There is no sign of that yet though, with policymakers still emptying their bottomless pockets to keep the
economy going.

In the UK, a £100bn increase in quantitative easing from the Bank of England has been announced.

The latest initiative in the US is a $1tn infrastructure plan, which would provide a much needed national upgrade of roads and bridges that has been inhibited through fiscal penny pinching and political point scoring over the first three years of President Trump’s term.

This week the Federal Reserve are still increasing their stimulus measures beginning their purchases of corporate bonds in earnest.

In Germany, a reduction in VAT has been announced as part of a more comprehensive stimulus package. That will mean a steep fall in the German consumer price index when it takes effect and subsequent steep rise again when it abates.

The stimulus forms part of a larger package of measures designed to support the economy over the remainder of
this year and into next year. Aside from the VAT cut, there is more investment and more support for businesses.

Perhaps most importantly though this comes at a time when Europe is preparing a coordinated aid fund and was
launched in the same week as the ECB announced a big monetary stimulus.

The central bank increased the size of its Pandemic Emergency Purchase Program (PEPP) by €600bn from an
initial €750bn and extended the horizon for purchases to at least the end of June 2021 (from the end of 2020).

Oil and prices
Market confidence has also been fed by oil prices, which have continued a rally that began at the beginning of May. The latest strength is thanks to an agreement reached within OPEC+ (the OPEC countries and Russia) to extend production limits until the end of July.

Oil has now risen by 100% since its low in late April (much more than this from the negative prices briefly suffered in mid-April). Gasoline prices have already risen 15% and we can expect considerably more as prices normalise.

All else being equal that means we will start to see higher inflation figures from April next year. They may well be
illusory – any rebound in the price from all-time low levels is going to appear inflationary, even though it may just be a return to something like normal – but it can nevertheless sometimes affect sentiment if sharp enough.

Where does that leave markets now?
The events of recent weeks have done little to alter our overall view of the next twelve months.

For now, there is a very accommodating monetary and fiscal environment supporting markets. At the same time,
sentiment remains similarly downbeat to where it was last year – when those circumstances led to a very strong
market. Weak sentiment is paradoxically a great indicator of a good time to invest.

When people are worried about the future and things start to improve, they are reluctant to overcome that fear and take the plunge. There are two ways in which this can harm them. The first is the fear of missing out, often abbreviated to FOMO. By being reluctant to buy into the market when it is weak, investors can end up being sucked into it after it has risen.

Despite the generally positive environment there is certainly the potential for a pull-back and any number of unforecastable things could happen, including the muchfeared second wave.

But for long-term investors that doesn’t make much difference. Investing in a balanced portfolio at the start of
each year from 2006 to 2010 gave a spread of returns from 157% to 112%. The best was achieved by investing in 2009 at the market bottom, but the next best were the earlier years where despite suffering the full impact of the biggest post-war bear market, investors still benefitted from that extra time in the market.

Which brings us to the second way in which worries about the future can harm our financial security: actually missing out, rather than the fear of missing out. If you missed the bottom, bad luck. Another one may not come along for a long time, after which you may miss it again. The best time to invest is over a long-term investment horizon, across an appropriately diversified range of assets.

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