The corona virus has wiped out large swathes of the economy. A huge amount of production and consumption has stopped. Revenues at businesses have plummeted. Many businesses which were completely viable in January are unable to meet their expenses or pay their creditors in March. There is the potential for a negative chain reaction among these creditors which are banks, investors, states and then ultimately the central banks. Recession is inevitable. And a depression is a possibility depending on how long this lasts.
But with interesting in all this is that apart from the initial reaction in Mid March, the stock market has barely budged. Looking at the S&P500 total return which includes dividends, it is only down 6 % over the past year and it is higher now than it was in January 2019. At present prices, it is by no way discounting the effects the corona virus will have on economic growth. Nor it it discounting, any possible future tax increases by governments as a result of current stimulus packages introduced.
When someone buys a share in an S&P 500 Index fund, paying $26.60, they are buying an asset that consists of America’s 500 largest publicly traded companies that earns $1.33 per share. In other words, the S&P 500 is trading at 20x the most recent twelve months of earnings.
20x earnings for the S&P 500 looks expensive considering its historical valuations of 15x earnings.
But here’s the kicker. It appears that the earnings of corporate America are currently contracting at a 15-25% rate according to the St. Louis Federal Reserve. If we take the 20% figure and apply that haircut to the $1.33 per earnings of the S&P, the earnings are really $1.06 right now. At a price of $26.60, that would suggest a P/E ratio of 25!
So what gives? Why is the S&P 500 trading at record valuations when clearly there is contraction to economic growth coming.
The answer is interest rates.
Interest rates have been at historic lows over the past 10 years and got cut even further recently in order to stimulate economic growth. There is a growing consensus now that interest rates won’t rise over the next few years. And even when the do begin to rise, it’s hard to see them reaching anything higher than 2%.
So what does this mean for stocks?
In short, stocks have now become more attractive.
You see, there is an inverse relationship between interest rates and stock valuations. When interest rates are high, fixed income investments such as bonds are more competitive and therefore stock valuations fall. Conversely, when interest rates are low, fixed income is less competitive and therefore stock valuations will rise.
Take a saver who has £500,000 in cash. If they leave the money in cash in a current account, they will receive zero income in cash. In fact, the cash would devalue year over the year due to inflation.
On the other hand, they can put it in bonds or a savings account. But with the best accounts paying only 1%. our saver would only receive £5,000 a year in income, no where enough to live on.
On the other hand, by investing in stocks and receiving a dividend yield of 4%, they could be earning £20,000 in income a year. Clearly the income from dividends is not guaranteed – but even if it fell by 20%, it is still in sharp contrast to what is available elsewhere.
To many savers and retirees, there seems to be no viable alternative to the stock market at present. It is the only game in town.
And with everyone buying into stocks, it pushes the prices and the valuations higher. This might be one of the reasons markets have roared back quickly after the initial mid March falls.
There are other reasons of course for the markets moving higher such as the stock market being a leading indicator i.e. it moves higher much before any economic recovery and also central banks around the worlds willingness to buy up stocks.
With all the above factors at play, the question is, will stocks ever be cheap again?