Feeling baffled by this erratic stock market? You’re not the only one.
Security prices always incorporate conflicting views about what lies ahead. Right now, though, the difference in opinions has reached historic proportions.
Consider, for instance, the record degree of dispersion in estimates for corporate earnings this quarter. According to analysts at Bank of America, analysts’ profit forecasts have never disagreed so violently as they do right now, not even in the depths of the financial crisis a decade ago.
Then there is the remarkable divergence between share prices and bond prices. The two major asset classes are telling starkly different stories about what lies ahead for the economy.
For the most part, share prices display optimism that corporate earnings will bounce back quickly once the pandemic is contained.
Reflecting this upbeat viewpoint, the MSCI USA Index of mid-sized and large stocks is now trading at its highest price-to-earnings ratio since the dot-com bubble popped in 2001.
This has happened because share prices have staged a strong recovery from their lows of a few weeks ago at the same time as earning projections for the year ahead have tumbled. The combination of the two trends has pushed the forward price-to-earnings ratio skyward. Contrary to what you might expect, stocks have become even more expensive despite an imploding global economy. Stock markets seem to be counting on a scenario where business activity rebounds strongly the moment that lockdowns are lifted.
But bond markets? They aren’t buying the fast-rebound story. They remain steadfastly downbeat, not just about the next few months, but about what is to unfold in years to come.
The 10-year Government of Canada bond, for instance, is paying a mere 0.6 per cent a year. That miserly yield doesn’t even offset the expected bite of inflation, let alone deliver a return in real terms.
Anyone who buys these bonds is signing up to see his or her buying power diminish, year after year, for a decade to come. This only makes sense if you expect the alternatives to be even worse.
Perhaps they will be. Earnings per share for global stocks are likely to collapse in half this year, according to Robert Buckland, equity strategist for Citigroup.
In a note this week, Mr. Buckland observed that one simple rule from previous global recessions is that share prices eventually fall as much as earnings per share.
“That rule suggests that global equities should fall around 50 per cent this time round,” he wrote. Maybe central bank stimulus will limit the decline on this occasion, he acknowledges, but investors should still keep in mind the possibility that stocks may hit new lows this year.
So what conclusions can investors take away from this murky and rather dispiriting picture? Here are four observations:
It is all about the virus
As Mr. Buckland notes, traditional valuation methods don’t shed much light on what to do right now. What matters more is how the world progresses in containing the novel coronavirus. Until that is accomplished, any forecast for the economy, or for corporate earnings, is nothing more than a guess.
Bonds look like a long-run loser
Today’s low bond yields reflect frantic buying by central banks, which are scooping up bonds in a bid to revive their economies by keeping borrowing costs low. (Bond yields move in the opposite direction to bond prices.) Most safe government bonds are now priced at levels that guarantee to erode an investor’s buying power.
One striking example is long-term inflation-protected U.S. Treasury bonds, some of the most secure investments on the planet. Safety-conscious investors have bid up their prices to the point where real, or after-inflation, yields are now below zero.
This is noteworthy because the yields on these bonds are a decent proxy for market expectations of real economic growth, according to analysts at the Man Institute. Judging from today’s dismal yields, many bond investors are, in effect, bracing for a no-growth decade ahead. That seems unduly pessimistic.
But stocks are no bargain
Stocks may have more potential than bonds for gains, but at their current prices, they are far from cheap.
Look, for instance, at the cyclically adjusted price-to-earnings (CAPE) ratio of major stock markets. CAPE measures how current share prices compare with the past 10 years of underlying earnings. It offers a quick guide to how share prices stack up against a market’s long-run ability to generate profits.
In both Canada and the United States, markets are trading well above long-run CAPE averages, according to Capital Economics. In the U.S., stocks are changing hands for nearly 29 times their average annual earnings over the past decade. In Canada, the figure is closer to 21. Historically, CAPE has averaged around 16.
Some areas are cheaper than others
There may be at least one ray of light. As these numbers suggest, markets vary widely in valuation.
John Higgins of Capital Economics notes that U.S. stocks look particularly pricey compared with those in other markets. Given their relative cheapness, non-U.S. markets are likely to perform better than U.S. stocks over the rest of this year, he says.
GMO, a money manager in Boston, predicts a dismal outlook for U.S. stocks for several years to come, as high valuations come back to earth. In contrast, stocks in emerging markets are cheap and should produce impressive returns in coming years, according to GMO.
Investors who are prepared to be patient may want to start looking outside North America in search of better returns.
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