History is littered with examples of poor economic realities – but decent, if not great, stock market returns. The last twelve months’ remarkable rally is another example of why one should not make drastic portfolio changes given the current economic-fear du jour.
This time last year, the global pandemic was just hitting its stride. International equity markets had begun a bear market, shortly followed by U.S. equity markets, ultimately culminating on March 23rd in a peak-to-trough decline of more than 30%. Some sectors like REITs and MLPs neared or even exceeded a 50% decline.
At the same time, economic data was just beginning to weaken, with final Q1 2020 GDP down 5% from the prior quarter. It was then down 31.4%(!) by the end of Q2 2020. Meanwhile, the unemployment rate jumped from a record low of 3.5% at the end of February to 14.8% in just two months.
Of course, history has now been written. 2020’s “Covid-Crunch” bear market was quickly resolved by a new bull market within the shortest timeframe in history – just one month! Normally bear markets last, on average, ~22 months. While this short-duration bear market was abnormal, the ability of markets to recover in the face of worsening economic data is routine. Recall the Great Financial Crisis – unemployment began increasing materially in 2008, culminating at the end of 2009 at almost 10% unemployment. GDP likewise declined, contracting by more than 5% for two quarters in a row, the first time since the Great Depression.
Yet again, what happened in the stock market? The U.S. equity market dropped to its low on March 6, 2009, 28% below its value at the start of the year and over 50% below its value from the peak in 2007, only to recover and end the year up 23%.
These latest recovery examples are not just a symptom of aggressive Fed intervention. These kinds of disconnects with current economic realities have been documented long before the Fed was created in 1913. Why is this the case? The basic answer is that stocks are a crowd-sourced bet on the future of each individual public security in the market. Future economic success (or failure) is clearly an influence on the value of a company – Will the upcoming environment be generally good or bad for sales? – but today’s economy is not the one investors are worried about.
In technical terms, investors (thoughtful ones at least) are “discounting” the stream of future earnings to the present. They take current (or forecasted) interest rates to determine the present value of all those future earnings and cash flows. All things being equal, if current discounting interest rates are low, the value of those future earnings are higher – and vice versa. A Fed-supported perspective that rates would stay low forever a long time has helped prop up markets.
This is not to say that the market is blind to winners and losers in the current environment. One only need to look at the first three quarters of 2020’s returns to see that the presumed “winners” made sense in a Covid-Crunch economic era. Businesses in the tech, communications, online/e-commerce and groceries sectors won, while businesses in the travel, leisure, energy, and some real estate sectors were under significant pressure.
In spite of those obvious winners during the Pandemic, the fourth quarter saw a big pivot: Smaller, presumably riskier, businesses outpaced their mega-cap quality brethren; value-oriented and cyclical businesses prevailed; and international and emerging markets outperformed domestic markets. Why? We had a sea change in political leadership that was seen as being more aggressive with stimulus and more lenient with global trade policies.
We also have a Fed that has continued to jawbone a healthy rate of inflation and dovish monetary policies off into the distant future. Plus, we’ve experienced the announcement of a COVID vaccine and continued development of effective therapies. In aggregate, these changes were assumed to boost the potential for higher GDP outcomes in the future. These presumed improvements found their way into the market values of these more cyclical businesses.
Are these outcomes fully appreciated – and thus priced – into the market? Will something come along that enhances (or suppresses) those potential realities? It’s easy to tell you what’s happened, and perhaps even why it’s happened, but the question will always remain: “What’s next?”
I wish I could sit here in good conscience and tell you we have the answer to that question. Although I hope you’ve gotten the message that the stock market is not the economy, there is one way to connect the two that is getting a lot of press lately. This is often referred to as the Buffett Indicator. To arrive at it, you take the current total market cap of the U.S. stock market and divide it by current GDP: The higher the ratio, the more expensive the market and vice versa.
At the time of writing, the ratio stands at an all-time high of 192.1%. Imputing an adjustment based on the current Fed balance sheet puts the ratio at a less breathtaking, but still substantial, 141.9%. Based on historical ratios, these levels are “significantly overvalued” and portend potentially negative forward rates of returns for U.S. stocks.
One problem with this ratio, as with any valuation metric, is that it tells you nothing about timing. By this metric, the U.S. stock market has been “significantly overvalued” since 2017. Even at the lows of the Covid-Crunch, the market was still “modestly overvalued.” In hindsight, returns since those time frames have been ample and may continue to be for quite some time.
The reality is that market forecasting is impossible. We can make educated guesses and we may be right; but as discretionary investment managers, if we are off it is your future. Don’t get me wrong, we can and will make tweaks to allocations and investment products based on probable outcomes, and will rebalance and tax-loss harvest when markets get extreme. At the end of the day however, we check our hubris at the door and broadly diversify our clients’ portfolios in an effort to ensure that no single market or economic outcome defines our clients’ futures.
If the “Buffett Indicator” is right, the diversifying elements we’ve put in place may come in handy. But it also stands to reason that the market’s currently lofty level may be telling us about more positive economic outcomes than we can currently fathom.
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Halbert Hargrove Global Advisors, LLC (“HH”) is an SEC registered investment adviser located in Long Beach, California. Registration does not imply a certain level of skill or training. Additional information about HH, including our registration status, fees, and services can be found at www.halberthargrove.com. This article is provided for informational purposes only and should not be construed as a solicitation to offer personal securities transactions or provide personalized investment advice. The views contained herein are not to be taken as an advice or recommendation to buy or sell any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without previous notice. This material should not be relied upon by you in evaluating the merits of investing in any securities or products mentioned herein. In addition, the Investor should make an independent assessment of the legal, regulatory, tax, credit, and accounting and determine, together with their own professional advisers if any of the investments mentioned herein are suitable to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment.
 Seasonally adjusted at annual rates; source: https://www.bea.gov/data/gdp/gross-domestic-product
 U.S. Bureau of Labor Statistics
 J.P. Morgan Guide to the Markets, US JAN-1-2021
 U.S. Bureau of Labor Statistics
 https://www.gurufocus.com/stock-market-valuations.php; as of 3/10/2021