A tumultuous first half
Although Canadian stocks were closed for trading on Canada Day, U.S. equity and credit investors ushered in the first day of Q3 with another rally. This comes after U.S. stocks finished Q2 with a gain of 20%, marking the best quarter of performance for the S&P 500 Index in 22 years.
While the fear trade dominated Q1, investor optimism was prevalent in Q2. This optimism centered around human ingenuity and the development of a COVID-19 vaccine, the quick turnaround of a devastated economy shut down from a Black Swan global pandemic, and faith in the power of policymakers to rescue markets from ceasing to function. Investor optimism has recently been tested as four U.S. states – Arizona, Texas, Florida and California – have shown a worrisome increase in new COVID-19 cases as lockdowns ease.
In fact, stocks have essentially gone sideways in the past month as investors grapple with positioning after the furious stock rally leading into June. A key question for investors now is how to re-price risk assets for a possible stall in the economic recovery from the possibility of a second wave of COVID-19 infections. This investor uncertainty can be seen clearly in the performance of value stocks, which typically have more leverage to economic growth. As the chart below shows, value stocks have shown spurts of outperformance in the past three months, but their recent performance has faded again on worries that the reopening of businesses will be rolled back due to the increase in COVID-19 case growth. Until investors have more conviction that this economic recovery will take hold, which should also translate to a higher 10-year bond yield, investors will likely continue their preference for growth stocks over value stocks.
While the extraordinary stimulus measures delivered by policymakers have undoubtedly underpinned the stock rally from the March 23 lows, investors have also taken comfort in the positive rate of change in traditional economic data, and in the broad improvement of high-frequency data. Due to the speed and intensity of this COVID-19 recession, traditional economic indicators are out of date by the time they are released. To better gauge the timing of an economic recovery, the dashboard below sources a group of high frequency, alternative and market indicators for Canada. The latest figures paint an economy on the mend with improving mobility indicators and consumer sentiment. More importantly, it also shows a diminishing COVID-19 case count.
After such a tumultuous first half of 2020, it’s difficult to imagine an even more eventful or volatile second half of this year. Investors should definitely be mindful of the COVID-19 second wave scenario as that represents the biggest risk to the resumption of economic growth and the durability of this stock rally. Investors should also prepare for volatility in the October and November time frame as the U.S. presidential election takes place on November 3.
Lastly, stocks look expensive on most valuation metrics. As I wrote in April, stocks are forward looking and have been quick to discount an economic recovery before confirmation from economic data and corporate earnings. So it’s worth noting that analysts’ earnings forecasts for next year are stabilizing, and we even saw a very slight uptick in estimates this week. Earnings will need to catch up to stock prices to allay the obvious concern of an expensive stock market.
However, valuation is an ineffective tool for projecting where markets are headed in the short to medium term. Stocks can stay overvalued or undervalued for long stretches although, over the long term, prices eventually reconcile with fundamentals. The two graphs below show the relationship between the P/E ratio of the S&P 500 and its return over the next 12 months, and over the next 10 years. Over the period of the next 12 months, the relationship between forward returns and valuation is probably best described as noise. The second chart makes clear though that valuation is a good predictor of returns over the next 10 years.
And with the next batch of quarterly earnings from U.S. companies due to be released starting mid July, investors will receive a fresh set of data points on the trajectory of corporate profits and the health of the U.S. economy.
Lieh Wang, CIO
CWB Private Investment Counsel