What is Driving the Stock Market?
COVID-19, presidential elections, stimulus, and zero interest rates. What in the world is going on with the markets? Join me along with Bud Kasper, President of our Lee’s Summit office, as we discuss what is driving the stock market.
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What’s Driving the Rapid Stock Market Recovery?
Dean: Okay, Bud, here we are, we’re having this conversation on July 29, 2020.
Bud: Yes, indeed.
Dean: We’re just about through the hot month of the summer, and it’s been a hot month in the stock market. We saw some good things happen and nice recoveries. I think the big thing on people’s minds is, “What is driving the stock market recovery to be so rapid? What is driving the stock market?”
The confusing part to a lot of people, and quite honestly, can be confusing to professionals like us with 70 years of combined experience. Companies are having a hard time even providing guidance on what their earnings will be because the economy is still in disarray from COVID-19.
Bud: No doubt. I mean, let’s face it, some businesses are absolutely shattered. Now, you ask, “What is driving the stock market and this economy at this particular time?” The market is reacting to the stimulus program coming in from the government and the Federal Reserve, keeping the rates low. But more importantly, the Fed coming in and taking control of the bond market, which was a critical situation. I’ll make an even bolder statement that when the Federal Reserve finally came in and said, “We’d be the buyer of last resort of all bonds.” That was perhaps the scariest information that I ever have come across in 38 years. If the bond market were to collapse while the stock market was also collapsing, the insecurity associated with it could have been catastrophic.
Many Unanswered Questions
Dean: If we look at the Great Recession of 2008, and when we headed into 2009, things still looked bad. There was still an awful lot of uncertainty. And yet the market rebounded aggressively in 2009 after its March 9, 2009 lows. The reason it rebounded aggressively was that the Federal Reserve enacted a zero interest rate policy. In that commitment to keep that interest rate low and the quantitative easing, which was also a stimulus, the term, “Don’t fight the Fed!” was coined and became very accurate.
Even though there’s so much uncertainty with corporate earnings, and people don’t know what’s coming next they’re asking questions like, “When are we going to get back to full employment? When will the consumer be able to go out and spend and do what they normally? Will there be a vaccine this fall? What about in the spring? Will there ever be a vaccine?”
We don’t know the answers to those questions. But what we do know is that we have the support of the Federal Reserve, and we have the support of the United States Congress and President. I think the market believes the government will do anything necessary to keep the economy going and prop up the markets, whether it’s the stock market or the bond market.
It was evident when we started seeing these, you know, multi-trillion-dollar stimulus packages come out, the stock market just takes off. Let’s take a look at what’s going on.
Bud: Let me add one thing to your comment. March 9, 2009, as you noted, was the low point. We didn’t see a sudden surge back into the stock market. It took the entire summer for competence to come back in from the Federal Reserve Program.
Index Performance Year to Date
Figure 1 | Source: Chaikin Analytics
What we’re looking at in Figure 1 is the different indexes on a year to date basis. And so we have such disparity in where returns are and where returns are not. Looking at this chart, the red line near the bottom is the S&P 600 SmallCap. We can see that SmallCaps are still down on the year 16%. That’s huge. No reward there.
Let’s jump up to the S&P 500, which is essentially a flat line. It’s down by 0.21% right now. Alright, what’s up at the top? I don’t think it’s any surprise it’s the NASDAQ composite. The NASDAQ composite is higher by 20%. What’s that telling us? We see a 37% differential between SmallCaps and technology, or the NASDAQ, this year in seven months. What’s that tell us?
Bud: Well, I think we have a situation where the five big companies in technology are driving the returns, both for the S&P 500 and the tech sector. It does explain what we’re experiencing at this point. If you look at it right now, the S&P 500, 25-26% of the return to the S&P 500 comes from technology, and specifically, those five companies, Facebook, Amazon, Microsoft, Alphabet, and Apple.
What About Bonds?
Dean: Now, that’s happened before, right? It happened in 1999, just before the Dot Com Bubble.
So what are people saying today? “Well, if I’m going to make money, I need to own big tech.” And right now, it’s true. Go back to 1998, 1999, Bud. What people were saying back then was, “You know what? The old style of brick and mortar value companies forget about them. Everything now is going to be technology.” And when the tech wreck happened, we saw technology dropped by 70% within two years.
Bud: Versus 47% for the S&P 500 for the same period.
Dean: But what did well in 2000 and 2001?
Bud: Bonds!
Dean: Right, bonds, financial stocks, and high dividend-paying stocks. So good old value did very well. The point I’m making is, don’t get to a position where you’re always just chasing the performance. Don’t forget about asset allocation. Don’t forget about diversification. Sometimes you might feel like you’re missing something, but if you want to make sure that you’re smoothing out your ride as much as possible in the equities market. You still have to have diversification.
What’s Going on in the S&P 500?
Bud: Yeah, from a historical perspective, if you think of the 20s, 30s, and 40s, Dean, what was the way we judged performance in the stock market? The Dow Jones Industrial Average. Why? Because we were a manufacturing economy at that time. In 1957, Standard and Poor’s came in and said, “That’s not a fair way of looking at the market today.” So, they divided the market into 11 different sectors, and they filled each of those sectors up with stocks that best represented this sector. And that was a good way of truly measuring what the broad-based market was doing.
But if I were to tell you that technology today represents 26% of the S&P 500 return, what does that tell you? The S&P has been biasing the portfolio to technology. Why would they do to do that? They’re seeing all this money coming into pension plans, IRA accounts, and individual accounts getting invested in the S&P 500. And if that were to perform equal-weighted, you wouldn’t get the returns that you’re getting out of the S&P 500 you do today.
Sector Performance Year to Date
Figure 2 | Source: Chaikin Analytics
Dean: Well, here’s why. Take a look at Figure 2 above. Figure 2 shows us the different sectors on a year to date basis. Let’s start up at the top with information technology year to date, plus 15.21%. You can scroll on down, and we only see four sectors that are in positive territory. When we get to the S&P 500, it isn’t a sector, but it’s more of a benchmark. It’s the one that’s flat. Okay, so what do we see? Consumer staples, negative. Materials, negative. Utilities, negative. Real estate, negative. Industrials, negative. Financials, negative. Down at the bottom, which shouldn’t be a surprise, is energy, negative 38%.
You see a 53% variation between the best sector and the worst sector in the S&P 500. The average of those sectors, as weighted inside the S&P 500, gives us the flat return this year. But you can the tendency to want to be overweighted in technology because that’s where the money is being made.
Is the Stock Market Overvalued?
So I think the question that we have to ask is, and a question that we’re always asking, “Is the stock market overvalued?” Is it undervalued? Or is it fairly valued?” I would encourage everybody to check out the blog post that my brother Shane, one of the partners here at Modern Wealth Management, wrote on market valuations. It’s a very detailed and in-depth article. We’re going to go over just one slide out of that particular article. But if you do read it, you’ll come away with the conclusion that the markets today are indeed overvalued.
Bud: From the perspective of earnings and everything, and Shane did a great job in that article. I encourage everybody to go and read it. When we look at this moving forward, though, what concerns do we have? Well, the Coronavirus is number one, but number two is the election. What possible consequences could it bring to the stock market once the election is over?
Dean: It goes back to this whole concept when we do financial planning using our Guided Retirement System™. We do our best not to take any unnecessary risk; in other words, don’t get greedy. Don’t take on more risk than what your portfolio needs for you to be able to meet your financial objectives.
Valuations, What Should We Expect?
Figure 3 | Source: Advisor Perspectives
Let’s take a look at this valuation chart in Figure 3. This one particular chart compares four different measurements of valuation. There’s the Crestmont PE from its geometric mean, the Shiller Cyclical PE, and then the Q ratio. Also included is the S&P 500 from its regression.
The best valuation you can see in Figure 3 is the CAPE ratio, the cyclical PE 10. The CAPE ratio shows the market is now at 88% overvalued. Down at the bottom, you can see the years. So in 2000, you can see the Dot Com Bubble, right? If you take a look at where we are today with different valuations-
Bud: It looks rather similar, doesn’t it?
Dean: That’s right, that’s what we’re talking about is the similarity to today. Just because valuations are where they are today doesn’t necessarily mean that they come crashing down, right? There are two different ways that those valuations can get lower. We need to see better earnings, and that will bring those valuations down.
Bud: For that to happen, the economy has to recharge.
Dean: We’ve got to get that economy recharged. And I think we’ve seen this surge in the valuations because corporate earnings have fallen off a cliff. Right?
Bud: Yes.
What to Expect in the Economic Recovery
Dean: As the economy recovers, and you can see it happening in the market today, the bet is, “The Fed is coming in, Congress is coming in, we have stimulus, and we have zero interest rates. They’re not going to let this economy fail. They will keep it going for the good of the American public and for the good of the normal taxpayer out there trying to earn a living.” Right?
Bud: Right.
Dean: When this does recover, I believe these price-to-earnings ratios will start coming down naturally. However, we have to be cognizant that we may not get a vaccine in the fall or spring, and this COVID situation could go on for another 18 to 24 months. If it does continue, I don’t think there’s any way that these valuations can hold up for that period.
Bud: I agree wholeheartedly with that. In the interim period, the stimulus is so great that it should probably continue to drive the stock market would be my guess. I think we’re going to have flat returns getting closer to the election. After that point, Katy bar the door; I don’t know what’s going to happen.
Two Factors in Economic Recovery
Dean: What happens after that, Bud, depends on two things:
- Who wins the election
- How soon will we get a vaccine
Bud: Right.
Dean: So, until then, you and I and all of our advisors here at Modern Wealth Management are looking at this every single day. We’re keeping an eye on your portfolios. I want to encourage you to share this information with your friends, share the video, subscribe to us on YouTube, and follow us on Facebook. Stay tuned-in with the different content that we write every week and the videos we put out.
We appreciate you being part of Modern Wealth Management. If you’re not a client and you’d like an opportunity to visit with one of our advisors, give us a call or schedule a complimentary consultation below. Let us know that you’d like to have a conversation. We’ll set up a no-obligation visit, which can be done by phone, zoom meeting, or you can come in in-person like Bud, and I are sitting here next to each other today. I hope everybody stays healthy and stays safe. Thanks for taking the time to join us today.
Dean Barber
Founder & CEO
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The views expressed represent the opinion of Modern Wealth Management an SEC Registered Investment Advisor. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.