What’s next after the rally?

 

This post reviews summarises the bull and bear views for the coming year.

The bear view is captured by respected value investors such as Jeremy Grantham (GMO) and Howard Marks (Oaktree Capital). Grantham had called the last 3 great bubbles, exiting Japan in 1987, fighting the tech bubble in 1998 and getting out in 2007 before the housing bust. The current Covid situation is viewed as highly bizarre with the stock market in the top 10% of historical price earnings ratio while the US economy is arguably in the worst 1% in history.  Unsurprisingly, Grantham urges caution and patience.  In fact, he urges his listeners to look at portfolio protection on the downside. Interestingly, outside of the US, International and Emerging markets continue to look attractive to GMO with double digit expected return.

Howard Marks latest memo simply points out that there are three stages to a bull market rally. The first stage, when only a few unusually perceptive people believe improvement is possible; the second stage, when most investors realize the improvement is taking place; and the third stage, when everyone concludes everything will get better forever. The first stage began in mid-March and stage two was brief. We’re clearly in stage three. The entire market appears to focus on the positives and overlooked the negatives. Marks concludes that the powerful rally so far is built on optimism and has incorporated positive expectations and overlooked potential negatives. It’s been driven largely by the Fed’s injections of liquidity and the Treasury’s stimulus payments. Investors assume that these actions are free from highly negative second order consequences. Marks thinks the odds for the future aren’t in investors’ favor.

The bull case is captured by Wharton finance professor Jeremy Siegel of the “Stocks for the Long run” fame. He thinks that Dow Jones is likely to hit 30,000 by year end (that’s almost another +20%). He argues a lot of the uncertainty now is regarding a Democratic sweep on Election Day 2020 and a risk that the corporate tax cuts implemented during the Trump administration may be reversed. If we get a resolution of the political uncertainty, then the market would be operating in highly favorable conditions.

The other proponents of the bull market make the argument that the current price of the stock markets anticipates future earnings or dividends, with a discount applied for the cost of money and risks. The cost of money part of the discount rate is essentially the lowest it’s ever been. If you discount earnings at 10%, then $100 of earnings in 50 years’ time is worth about 85 cents today. Discounting the same at 1% means $100 of earnings is worth about $60.80 today. This then brings us to the so-called Fed Model (confusingly, it’s not endorsed by the Federal Reserve). The Fed Model is bullish as long as the earnings yield or earnings to price ratio of the SP500 (currently 3.7%) is above the 10-year Treasury (currently 0.68%). There are multiple criticisms on the model, not least that it’s based on some flawed assumptions. But it seems to work well to describe how market investors perceive current market P/Es. This relationship is strong and clear over time. Low interest rates help explain why investors assign a high stock market multiple. But it’s not clear that low rates justify high multiples for a wide variety of cash burning, loss-making stocks.

We continue to believe that good quality international stocks, with pricing power, purchased at reasonable prices, will be the right asset class to weather the uncertainty. If you’re an accredited investor, do make an appointment to chat more.

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