A Fast Stock Recovery Is Being Met with Strong Negative Economic Data
As more data is becoming available, we are beginning to see how the economic shutdown is impacting growth. The Bureau of Economic Analysis released its first estimate of U.S. Real GDP growth in the first quarter and it came in at a negative 4.8%. The average economist surveyed by Dow Jones thought the economy would contract by 3.5%[i]
We have discussed on previous updates that the stock market is forward looking and moves up and down depending on expectations three to six months out. In other words, if market participants believe the economy, and therefore corporate profits, will rise six months from today, investors will begin to bid up the price of stocks in anticipation of better days. The same is true on the opposite side, if the markets think the economy will contract, bringing down corporate earnings, investors will sell their stock today before things get bad.
That is what we observed in March; people began to sell when it was realized that COVID-19 would take a toll on the economy.
Markets, however, are known to overshoot on the upside and downside when it is attempting to find equilibrium. From the all-time high set on February 19th to the March 23rd low, the S&P 500 dropped 33.9%, marking the fastest drop of its kind in history. At that time, we were saying we would see bad economic data in the next few months, but that the markets had overshot on the downside. As a result, we made changes to our portfolio with the expectation that markets would try to find balance and likely move up.
That is what happened. Since the March 23rd low, until April 30th, the S&P 500 has rebounded 30.2%. However, we did not think the markets would move up to these levels this quickly. What we are seeing is that the market is now overshooting on the upside. Three data points that bring us to this conclusion are:
- Valuations on the S&P 500 are not cheap; the next twelve-month forward price-to-earnings ratio is at 20.4x compared to the 25-year average of 16.3x[ii].
- The economic data being released is worse than the consensus, and as data is revised, the numbers are looking gloomier.
- The percentage of stocks trading above their 50-day moving average have spiked.
Any one of these data points on its own would not be concerning, but when you begin to see a pattern, a clearer picture emerges.
Markets are operating as they should, buyers and sellers are trying to find the right price of the stock market given what is likely to happen to the economy and corporate earnings six months out. During this process, markets become more volatile. That is what we expect to witness over the next few weeks and months, so it would come as no surprise to see a pullback in prices soon.
We are reevaluating whether we should take some profits off the table from the recent gains and add to the cash cushion we have built in our portfolios. We are watching things very closely and we will keep you updated as we navigate through this market environment.
