Prices are high and pros are anxious, but it’s hard to fight the Fed and an optimistic mood.
Michael P. Regan
If the year 2020 wasn’t weird enough already, add this to the list: The U.S. is in the middle of a recession, yet some professional investors are worried that the stock market may be rallying itself right into a bubble.
While most Americans are still trying to avoid crowds to stem the spread of the coronavirus, investors are crowding tightly into shares of tech-inflected companies believed to have the least at risk from the economic disaster. To buy into the U.S. stock market right now means paying about $23 for every dollar of earnings from companies in the S&P 500, the most in a decade. The Nasdaq 100 Index’s valuation, at 34 times earnings, is the highest it’s been in more than 15 years. These numbers are unusually skewed to the biggest names, which investors have piled into. The five biggest American stocks—Apple, Microsoft, Amazon, Alphabet, and Facebook—now account for almost a quarter of the total market value of the S&P 500, compared with around 12% in 2015.
The cheapest price-earnings ratio among the Big Five is about 30. At 37, Microsoft Corp.’s is the highest since the euphoric dot-com heyday 20 years ago. That said, a few other names have also taken part in the boom. Tesla Inc., not yet in the S&P 500, is trading at 10,000 times earnings.
These valuations are all based on the earnings that have already been reported. Investors are willing to pay this much because they assume future earnings will be better. But when it comes to the market as a whole, future earnings are anybody’s guess, since a record number of companies have decided the outlook is too uncertain for them to provide investors with profit forecasts.
“It looks like the bubble we lived through in the late ’90s,” Scott Minerd, chief investment officer at asset manager Guggenheim Investments, told Bloomberg Television. That’s not necessarily a reason to bail on the market right now, he added. The “irrational exuberance” that former Federal Reserve Chairman Alan Greenspan warned about back then was in 1996—more than three years before the market peaked. “The nature of bubbles is they go long,” Minerd said. “It’s hard to predict when they end. Ultimately, there’s probably more money to be made in the stock market.”
For professional investors, it’s hard to stay on the sidelines even when prices feel high. If they sit out today’s gains, they may lose their clients before the market turns.
There are plausible ways for bulls to justify swollen valuations. The Fed is likely to keep interest rates exceptionally low for the foreseeable future, while also buying assets to prevent economic contagion from spreading to the corporate bond, mortgage, and Treasury markets. Those measures remove a lot of risk to share prices and reduce the competition from fixed-income investments.
That probably doesn’t explain it all, according to Liz Ann Sonders, chief investment strategist at Charles Schwab Corp. For her, the current environment brings to mind a famous formula from 20th century investment industry icon John Templeton: Bull markets are born on pessimism. They grow on skepticism. They mature on optimism. And they die on euphoria. “There is no fundamental term in that set of four sentences,” she says. “There’s nothing in there about valuations or earnings growth or GDP or retail sales. And I think there’s no better description of how market cycles work than that. It is all about the psyche of investors.”
For now, that psyche is split. There’s no shortage of skepticism, especially among the professionals. “If you said in January this disease, which at that time was circulating in China, was going to cause a global pandemic and terrible recession, would you think stock prices would stay the same as where they are now?” asks Ed Keon, chief investment strategist at QMA, a unit of PGIM Inc. that manages systematic quantitative equity and global multi-asset strategies.
But this year’s monetary stimulus from the Fed and U.S. Congress can’t be ignored. “We are cautious about taking too much equity risk,” says Keon. “But with the tremendous amount of stimulus that’s in the pipeline and strong momentum, we’re reluctant to take a very bearish stance, either.”
When markets push higher in the face of iffy economic and earnings data, the proximate cause is often professional momentum-chasers and hedge funds following quantitative signals. But they aren’t the only players here. In ascendance is a swollen corps of day traders taking advantage of a new world of commission-free brokerages and perhaps a dearth of ways to spend their time and disposable income, with many sports and other entertainment options still on lockdown.
Retail trading in 2020 accounts for about 18.5% of market volume in the U.S., according to Bloomberg Intelligence analyst Larry Tabb. That’s up from about 10% a decade ago and approaching the share of volume produced by hedge funds. The retail share can swell to 25% on the most active days in the market, Joe Mecane, Citadel Securities’ head of execution services, told Bloomberg TV on July 9. This all may lead to further frustration for investors clinging to the quaint notion that fundamentals should be all that matter in the stock market. At least temporarily.
For Wells Fargo strategist Anna Han and colleagues, the current environment has the potential for what’s known as a melt-up, or a ferocious lurch higher in equities that leads to an inevitable crash back to Earth. As she describes it: “It’s this exuberance, it’s investor risk-seeking that sort of gets ahead of itself. And when it does, you’re not sure exactly how long can it go. But you know that it’s more of a destabilizing push up higher in equities rather than a positive, encouraging move in the equity market.”
The problem with melt-ups is they have a habit of being followed by meltdowns. The catalyst for that could be, for example, disappointment if Congress is slower or stingier than expected with the next round of economic stimulus. Or it could be nothing other than a sudden shift of the market-sentiment winds, defying explanation.
This situation puts the Fed in an awkward position as well. The central bank’s monetary levers are meant to be pushed and pulled in an effort to boost employment and keep inflation from getting too hot or cold. A buoyant stock market may help the cause but is not supposed to be a primary goal. Guggenheim’s Minerd, who’s a member of a committee advising the central bank on financial markets, recalled his impression following a recent meeting of the group.
“I don’t think they’re sure whether to think of it as a bubble or not a bubble,” he said in his interview with Bloomberg TV. “One of the comments that was made at the meeting that I thought was interesting is: ‘How will we know if it’s a bubble?’ And the answer is: ‘After the stock market crashes.’” —With Sarah Ponczek