Fundamentals and the Market Rally

Thursday, June 25, 2020 |

It feels odd having stocks rally so hard and fast with such a high level of economic uncertainty and the potential for a COVID second wave. However, while the rally may feel odd it is NOT detached from fundamentals.

I will concede there is part of the rally that is speculative. This is evidenced by the higher than average Forward P/E ratio. Per JPM Morgan, that currently stands at 22 versus the 25-year average of 16.4. Further, certain parts of the market seem frothy.

Valuations at high levels are certainly a concern. It would seem the recovery has little margin for error and that future gains could be limited when stocks are priced this high. However, there are some caveats:

  • Currently this takes into consideration Q2 earnings, which will likely be the bottom. Once this rolls off, stocks should look more attractively priced.
  • Perhaps the market is ignoring 2020 and focusing on 2021. While still expensive, perhaps not as much.
  • There is no rule that valuations cannot go higher and improving fundamentals can help with that. Sentiment typically moves along with fundamentals.

Shifting back to fundamentals, it is important to remember that stocks look forward not backward. To that end, forward earnings in 2021 appear to be fantastic. Further, the rate of change through Q121 is improving and the adjustments to 2021 earnings are better than prior quarters (not shown; Source: Earnings Scout).

Source: S&P 500; S&P Dow Jones Indices

I suspect earnings are improving for two main reasons: 1) massive monetary and fiscal stimulus 2) COVID metrics are improving. Regarding #2, while we are seeing a spike in cases, deaths and hospitalizations (not shown) are still trending down.

Source: Google

Unless death or hospitalizations start to rise the probability of a second shutdown is low. If a second shutdown does not materialize, earnings growth is likely to be excellent in 2021 and not get cut substantially from where we are now. The other risk would be a premature pull back of stimulus, which seems very low on the monetary policy side. None of this means we cannot see a pullback from here of 10%-15%, but a move back to the lows seems like a low probability event.

The market will likely continue to move with the fundamentals, which are currently positive on a forward-looking basis. If that changes negative the market will retreat, but for now that is not what the data is telling us.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts or Lincoln Investment. The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. No person or system can predict the market.

Past performance is not indicative of future results.

S&P 500: The index measures the performance of 500 widely held stocks in the US equity market. Standard and Poor's chooses member companies for the index based on market size, liquidity and industry group representation. It is market capitalization-weighted. Investors cannot invest directly in an index.

Data (average monthly close) per Bob Shiller dataset from 1871 to 2019. Price data (month-end close)

Investing involves risk, including the loss of principal. There are some risks associated with investing in the stock markets: 1) Systematic risk - also known as market risk, this is the potential for the entire market to decline; 2) Unsystematic risk - the risk that any one stock may go down in value, independent of the stock market as a whole. This also incorporates business risk and event risk; and 3) Opportunity risk and liquidity risk.

Projections or other information regarding the likelihood of various outcomes are hypothetical in nature, do not reflect actual results and are not guarantees of future results. Additionally, it is important to note that information in this report is based upon financial figures input on the article date; results provided may vary.