A Big Third Quarter Jump and Then, a Slow Grind
As the economy continues its recovery from economic shutdowns, third quarter GDP growth came in at around 32%, annualized. Even with that gain, the economy is still far from where it was. The output gap – where we are now versus where we would be had COVID never happened – is still around 4%-6%. While that might not seem like much, it represents roughly $1 trillion of economic output. Closing that gap will prove to be difficult. The easy gains – if you can call $2.2 trillion in government stimulus and $3 trillion in liquidity via the Federal Reserve easy – have been realized. As the muddy water from economic shutdowns and massive government stimulus clears slightly, the toll of the pandemic response will start to come into focus.
Overall, unemployment is decreasing but long-term unemployment (longer than 27 weeks) is on a precipitous rise as more furloughs turn into permanent layoffs. Prime age labor force participation has weakened. This is likely due to parents dropping out of the labor market to support their children schooling at home. At the end of June, 16% of FHA mortgages were delinquent, setting a record on data going back to 1979[i]. Corporate defaults and bankruptcies are also on the rise. Total corporate defaults in 2020 surpassed the full-year 2019 number by July 1st, a trend that is unlikely to slow[ii]. The already weakened retail sector has been hit especially hard with bankruptcies. As of this writing, JC Penny, Neiman Marcus, Brooks Brothers and 24 other retailers have filed for bankruptcy in 2020 and more are expected[iii]. With these problems mounting, the road back to economic norms will be long and difficult.
COVID still looms large over the economic recovery. In Europe, case numbers had been low due to stricter lockdowns but are now on the rise, eclipsing levels seen in the first stage of the pandemic. In the US, numbers are still stubbornly high. Among developed nations, it seems only countries in Asia (New Zealand and Australia have also kept numbers low) have been able to consistently keep case levels low. Those low numbers are due in part to their people having recently experienced epidemics as well as more draconian governmental measures that people in the western world would likely find unpalatable. As an example, when someone tests positive in South Korea, they are placed in a government-controlled quarantine unit. Just try implementing that policy in the US. To use my favorite Midwestern colloquial, that dog won’t hunt.
As case numbers rise, it is unlikely we will see lockdowns in the US at the same level as in March, but some government regulations will likely be reinstated or persist. Local governments across the country are likely to enforce bar and restaurant closures early in the evening, limit large gatherings, etc. Also, while pandemic “fatigue” appears to be prevalent, people’s decisions are still impacted by the virus as they continue to play it safe. This will continue to suppress economic activity and slow jobs recovery. Governments around the world will try to counteract slow economic activity with additional stimulus. European countries have announced their intentions for the next round of stimulus, and eventually, the US government will come to an agreement on their next round of stimulus. Timing is still in question. It won’t happen before the election is decided and how quickly it happens afterwards will likely depend on the results. Congress, the White House and Joe Biden are all in agreement that stimulus is needed but negotiations continue about the amount and where it should be spent. The election will determine which party has, or will have, the leverage to get more of what they want.
A Bifurcated Market
The market recovery that began at the end of March has managed to hold together with a few bumps along the way. Growth companies, specifically technology, have performed extraordinarily well and have been driven to valuations not seen since 1999. Some current conditions do warrant higher than historically average valuations for some companies. First, interest rates are, again, at an all-time low. Fair Value in the financial world is, in part, a relative measure. Lower interest rates from government securities will generally result in investors being willing to pay a higher price for a company’s shares relative to their earnings. Secondly, it does appear that the pandemic has sped up some economic/market transitions: with many people working from home, the need for online collaboration tools and cloud-based services increased significantly, almost over-night. Furthermore, COVID shifted even more retail shopping online. Companies benefitting from these trends, like Microsoft, Google, and Amazon, have attracted a lot of capital the last few months pushing their prices to all-time highs.
The question is whether valuations have run too far ahead of financial results and reached levels that indicate “irrational exuberance.” For example, Tesla’s stock price has quadrupled(!) this year. It is currently worth more than Ford, GM and Toyota combined but has a fraction of their revenue. Its valuation currently sits at over 100x current and future earnings. We will freely admit that a price to earnings measurement and a comparison to traditional car companies is not enough to argue that Tesla is over-priced (though it is), but the differences are so extreme that some eyebrows are perpetually raised. The reality for Tesla and many of the other highly priced growth stocks may not be as bright as the market’s perception.
As the market beams with optimism regarding tech stocks, it drowns in pessimism in other parts of the market: healthcare, small cap stocks, value, banking, and energy have not enjoyed the same recovery in price as growth and tech. Again, this makes a degree of sense. The pandemic, the election, and court challenges have created uncertainty in healthcare; smaller companies are especially challenged by the COVID environment; cyclical stocks tend to rebound towards the bottom of an economic cycle; banks’ profits will be challenged by negative interest rates and a flat yield curve; energy is suffering from suppressed oil demand. But also again, the under-performance in these assets is extreme enough to raise an eyebrow or two. For example, in the last decade, companies classified as “value” have had the worst price performance relative to growth companies in two centuries[iv]. Performance in 2020 has widened this gap as the Russell 1000 Growth Index gained 24.1% through Sept 30 while the Russell 1000 Value Index lost 11.7%. This spread in performance may mean that the reality for some of these value companies may be brighter than perception.
Just as COVID looms over the economic recovery, it also looms over financial markets. Optimism could easily subside if COVID cases continue to rise, and governments implement economy dampening restrictions. We still believe the economic reality has yet to be fully revealed. Government stimulus has been effective in avoiding catastrophe but many of these measures are only a temporary relief from the economic symptoms of COVID shutdowns, not a cure. It is as critically important now as it has ever been to have a focus on valuation. We will continue to look for opportunities to investment capital at acceptable levels of risk.
Past performance is not a guarantee of future earnings. Asset allocation does not assure a profit or protect against loss in a declining market. Blake A. Stanley, CFP® is an Investment Advisor Representative of Legacy Advisory Limited Co. a Registered Investment Advisory Firm.