Hi folks, Brett Girard here with another Liberty Market Update. In our last video, we discussed how the stock market was pricing in Goldilocks Recovery of the economy. Although there may have been a few bumps along the way, this continues to be the case, at least for now.
The number one contributor to the stock market rally has been government intervention, through both monetary and fiscal stimulus. Over the last two months, this stimulus has been an invisible hand holding the economy together through both the closing and reopening. Now just to refresh, monetary stimulus is achieved primarily through two different means: interest rates and balance sheet expansion.
When trying to stimulate the economy, interest rates can be reduced. This pulls forward economic activity by encouraging borrowing through lower interest costs. Another mechanism for monetary intervention is through balance sheet expansion. There’s something called open market operations the Federal Reserve can purchase securities off the open market, and by doing so, inject cash into the financial system.
During this crisis, we’ve seen both interest rate and open market action. Coming into 2020, interest rates were already at historic lows. However, as the COVID crisis hit back in March, the Federal Reserve dropped the overnight rate down to zero. In the past, this has been quite stimulative for the stock market, but this time around, when rates fell to zero, we actually saw the stock market fall. This signaled that there needed to be more stimulus from a monetary perspective.
At that point, the Federal Reserve began to purchase securities—namely bonds—in order to keep the wheels of the economy turning. The size and scope of these purchases have been unprecedented and played a big part in the recovery of theS&P 500 over the last ten weeks. Let’s take a look at some charts.
This chart comes to us courtesy of Bloomberg. Let’s orient ourselves for a second before we get into the data.
Along the X-axis at the bottom, you can see we’re looking at the years 2009 through to 2020. 2009, as you recall, was the end of the last financial crisis, so this is mostly an expansionary time that we’re looking at here on the graph.
On the left-hand side, you can see the numbers 100 up to 350. This maps to that orange line, which is representative of the S&P 500. So that 350 is actually 3,500, which was just above the all-time top of the S&P 500, which we saw in February of 2020.
The white line maps to the right-hand axis. Here you can see 2M at the bottom, right? Up to 7M at the top right. This represents the number of dollars in trillions that the federal reserve on their balance sheet.
So beginning back in 2009, the S&P 500 and the Federal Reserve Balance Sheet moved in tandem through all the way to the middle of 2016. At that point, there was measures taken to reduce the size of the Federal Reserve Balance Sheet. And you can see there that the white line falls towards the bottom right through 2017, 2018, and into 2019.
At the same time, the S&P (that orange line) continues upwards through 2017, through 2018, and through 2019, until we have the correction of the recession that we’re in right now happening in 2020. Now there we can see a steep drop in the orange line (the S&P 500) followed by an increase in the white line (the size of the Federal Reserve Balance Sheet).
So what this shows is that we actually moved from about 4 trillion on the balance sheet through to 7 trillion in very short order. And it’s no surprise that as the balance sheet expanded, the S&P recovered, and this is where we start to see the beginning of that V-shape (the orange) back up to a level of about 3,000. And we’re a little higher today, but that’s where we are on the S&P. There’s a very tight relationship here, and it’s important to next look at how this relates to P/E ratios of the S&P 500.
This is another graph courtesy of Bloomberg. Again, let’s take a second and orient ourselves.
On the left-hand side, represented by the yellow line, what we can see is the size of the Federal Reserve Balance Sheet. In the bottom left, we have 1 trillion, up to 7.165 trillion on the top. On the right-hand side, represented by the white line, we can see not the price of the S&P 500 but the P/E ratio. Which, P/E, if you remember, stands for Price to Earnings—this is a valuation metric that tells us how expensive the market is. So there, at the bottom right, we can see a value of 10. That means you’ll need to pay a price of $10 for every $1 of earnings. And up to the top, you can see a value of 24.83, so here you’d be paying $24.83 for $1 of earnings. Now all things equal, you’d much rather pay a lower amount or have a lower valuation when you’re purchasing a stock.
As you can see from 2008 through to 2020, as the Federal Reserve Balance Sheet expanded, so too did the valuation of stocks in the S&P 500. In other words, they got more expensive. This trend really took off in 2020 where we can see the white line and the yellow line accelerating together, in tandem, from a P/E ratio of 18 (which is on a historical perspective, quite expensive), up to 24.83 (which is very expensive historically), as you’ll see in the next chart.
One last chart from Bianca Research provides some historical context on how expensive stocks are today. The blue line represents the S&P 500 Price to Earnings ratio since 1995. In this chart, we can again see the rapid rise in P/E through 2020 up to a rating of 25.4.
As discussed, this was due to the Federal Reserve Balance Sheet Expansion, but also the fact that earnings literally fell off a cliff as the governments around the world imposed their lockdown. It’s yet to be seen how earnings will recover, but it’s important to note that over the last 25 years, the current valuations are second only to the Dotcom Bubble—that peak you can see on the left side of the graph.
At that time, the P/E touched 27 in the last days of 1998. If you recall, the fallout from this rise in the Nasdaq was an 80% drop from peak to trough.
Turning to the economy, we’re quite concerned about the employment situation. This chart shows non-farm payrolls since 2014. Though the market’s rallied on the news 2.5 million jobs being added in May (you’ll see that slight up-tick in the bottom right), one look at this chart shows that in 2 months we dropped from well over 150 million employed people to just over 130 million. And really, there’s a long way to go in this V-shaped recovery. Double-digit unemployment has a significant impact on personal consumption, which at last check, makes up about 70% of GDP.
The biggest question going forward—as graphically displayed in a recent Bloomberg article—is what if, in flattening the curve around COVID, we created two curves of unemployment? The first sharp yellow shaded peak on the left will be the people that will return to their jobs as the lockdown is lifted. The lower, wider blue-shaded peak on the right is the collateral damage of businesses not making it through the lockdown and resulting in more permanent job losses. This could be the scar-tissues from the last couple of months that we’ll have to contend with for years to come.
And yet, in spite of all this bad news, the market continues to rally. This is where risk management comes into play. On the valuation space, the price to earnings were in the top 10% of what we’ve ever seen historically. That means that, statistically, unless earnings stage a meaningful comeback, we could only expect a 10% chance of going higher from here.
While not impossible, our questions remain. Is this runup in prices sustainable? What happens if the Federal Reserve stops or if the market views all of a sudden the stimulus to be insufficient? What happens if some of the lockdown job losses are other than temporary? And how does the economy function with double-digit employment?
It’s only going to be in the fullness of time that we’ll find out the questions and more. So, for the most part, we will remain with our asset allocations, as we’ve discussed. You’ll still continue to own your equities and participate in any further rally, your fixed income will continue to provide income (especially the longer-dated, higher-yield names in your portfolio), and the cash that you have will continue to collect nominal interest as we patiently observe the market and wait for an entry point.
As always, please feel free to reach out to David, Annie, or myself, as we’re always available to chat. Thank you, and take care.