The S&P 500 is just shy of its record high even as the U.S. economy has just suffered one of its ... [+]
At the time of this writing the S&P 500 is just a few points shy of its pre-Covid-19 record close. It seems just a matter of time until it breaks through that record, even as in the second quarter the U.S. economy had the worst economic contraction ofany quarter on record. The Nasdaq 100
This rally is profoundly counterintuitive for many people. The reasons behind it, however, are straightforward:
- A big part of the stimulus money is finding its way to the stock market;
- Corporate earnings are much better than expected; and
- Real interest rates are about the lowest they have ever been.
Stimulus money flowing to the stock market
As I wrote on my last post, a large chunk of the stimulus money is going to the stock market instead of the recipients the law intended.
A considerable amount of help reached those who needed it, to be sure, but hard data also shows that mutual funds and exchange-traded products received $860bn in inflows during the first half of 2020, and this does not even include purchases of individual stocks. Many reports also suggest that PPP funds and SBA emergency loans went to businesses that did not need them. Accounts of relatively well-off retirees who donated their $1,200 stimulus checks to churches or favorite charities are also not uncommon.
Earnings are much better than expected
According to FactSet, 83% of companies are reporting above-estimate earnings-per-share results for the current reporting season, which is the highest percentage since FactSet began tracking this metric in 2008. In fact, the average earnings exceeds estimates by 22.4%, which is also a record. In terms of revenue, both the number of companies reporting sales above average (64%) and the upward surprise (1.6%) are above their five-year averages.
One of the reasons for these better-than-expected results is that companies are turning temporary furloughs into permanent layoffs, which greatly improves their operating leverage but gives further proof that the huge and complicated government incentives to keep people in payrolls largely failed. A comprehensive report by CNBC quotes executives of major companies leaving no doubt that temporary job losses are now permanent.
This comes as no surprise. Expenditures such as travel and rent have plunged, as the new reality of virtual meetings and remote work sets in. The new practices not only affect transportation and office expenditures but also collateral industries like hotels and restaurants which are labor intensive.
It also helps understand the discrepancy between a Main Street that is mourning the loss of tens of millions of jobs and a Wall Street that is celebrating new all-time high in stock prices as cost-cutting layoffs boost results.
Interest rates continue to hover at historic lows
Other things being equal, lower interest rates mean higher stock prices. An example may help understand why.
Suppose that interest rates are 10%. In that case, $110 a year from now are equivalent to $100 today. This is so because you can invest $100 today at 10% and receive $110 in a year. If rates go down to 5%, $110 dollars a year from now are equivalent to $104.75 today, because you can invest that amount today at 5% and receive $110 in a year. In other words, the value today of any future payment goes up when interest rates fall.
Since a stock can be priced as the value today of the stream of all future dividends, declining interest rates boost the value today of that stream of future dividends. This is called the “dividend-discount model.” While this example is simplistic – much more goes into pricing a stock – it is true that even if a dividend-paying company has no changes in corporate earnings, revenues or margins, its stock price goes up when interest rates go down. Warren Buffet goes as far as saying that interest rates are “the most important” thing in determining stock valuations. While multiples like P/E ratios may seem high at the moment, they are unlikely to come down as long as interest rates stay low.
Solid foundations for the rally do not erase uncertainty
While large sectors of the U.S. economy are experiencing dismal conditions, there is no mystery to the bull market in stocks. The inefficient delivery of government stimulus, aggressive job-cutting by companies and some of the lowest interest rates on record are optimal conditions for the equity market rally.
This does not provide insurance against those sudden bouts of volatility that characterize the stock market. We still do not know, for example, when, how, or even whether the Covid-19 pandemic will end, and the potential for really bad news has not gone away. But in the short term it shouldn’t be a surprise to anyone when the S&P 500 reaches a new high.
