Market Outlook September: Will the stock market rise to the heavens, like the Tower of Babel?

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The mood is upbeat in the markets at the moment. Many leading sentiment indicators have had a V-shaped recovery. If the traditional correlation between these indicators and actual ‘hard’ figures is anything to go by, the macroeconomy should also show a V-shaped development, which should increase companies' earnings. However, this appears to have been already priced into the stock market. Most valuation multiples are high. The implicit extra return provided by the stock market compared to the fixed-income market appears to be well below the historical average. This, combined with the reduced possibility of further central bank stimuli and an increasing growth in the number of cases of COVID-19 infection, is one of the reasons why we are keeping equities in an underweight position while maintaining an overweight position in corporate and high-yield bonds as we enter September.

Driving forces for further stock market rises, or the absence thereof
There is currently a kind of euphoria in the market. The global stock market has succeeded in reversing just about the entire fall caused by the COVID-19 pandemic. The US stock market is now at a higher level than before COVID-19. This has not been driven by any extraordinary improvements in macroeconomic figures. Nor by earnings figures, as earnings for the second quarter have fallen sharply across the globe. Rather, it has probably been driven by the expectation that the COVID-19 pandemic won’t have any lasting effects. By the expectation of a V-shaped rebound for macro figures and companies' earnings. What could pull the stock market further up from here? Some scenarios have been mentioned repeatedly:

1. The euphoria train ploughs on, without it being possible to justify it financially in terms of sober figures for growth or earnings. That’s to say, the pursuit of returns continues, the stock market becomes even more expensive.

2. The monetary and fiscal policy stimulus is not only maintained, but markedly increased.

3. Macro and earnings figures are even better than what seems to have been priced in.

4. Mr Trump pumps up the economy and markets ahead of the election to improve his chances of winning.

5. The geopolitical uncertainty diminishes.

6. A vaccine is developed quickly.

Let's take a closer look at each of these scenarios. The euphoria train hurtling on, including the technology equities that have driven a large part of the stock market upturn, is not beyond the realm of possibility. But that euphoria will continue simply because of the euphoria is not a very convincing argument. Don’t forget that the market is now expensive, based on a number of valuation multiples. There’s a limit to how much more expensive it can become, given that there won’t be stimulus replenishments on the same scale as before the summer. In isolation, we use sentiment as a countercyclical indicator – i.e. we want to be cautious when optimism is being stretched, and vice versa.

Central bank and government stimuli will most likely continue for the foreseeable future. The level is important of course, but changes are often more important to the market, especially in the short to medium term, which is our investment horizon (6-12 months). With a US 10-year interest rate of 0.7 per cent and a corresponding German interest rate of minus 0.4 per cent, there is not much room for interest rates to keep falling. Further significant fiscal stimulus is limited by government finances, which have deteriorated from levels that were weak to begin with, and by fears of inflation (inflation expectations have increased significantly over the summer).

If macro and earnings figures turn out to be even better than what appears to have been priced in, this will not only be a V-shaped recovery, but something significantly stronger than that. It could happen, but it’s not our main hypothesis given that COVID-19 infection rates are on the rise again and other uncertainties prevail. We must also bear in mind that even before the COVID-19 pandemic, the global macroeconomy was not very strong, merely OK.

President Trump wanting to pump money into the economy in order to boost it and the stock market, is an oft-heard argument. However, if you keep in mind that the election is just two months away, there’s a limit to what Trump can do in such a short amount of time. We must also remember that it’s not just up to President Trump to adopt stimulus bills as and when he sees fit. He has a Congress to deal with. Congress has not even managed to agree on the next coronavirus package to replace the one that has now partially expired. Passing stimulus packages beyond this won’t be easy for Trump. We also note that many market participants have begun to question the gigantic US budget deficit. That uneasiness won’t exactly be reduced if Trump increases the deficit, and this could threaten the ‘safe haven’ status for US government bonds, in turn making it more expensive for the US to service its sovereign debt (i.e. higher US Treasury yields).

As for less geopolitical uncertainty, there is probably not much momentum to be found here for the stock market, as this risk is already quite low. The well-reputed geopolitical uncertainty index from is not far from its lowest level in the last twenty years.

We must be careful about commenting on a coronavirus vaccine, as this is not our field of expertise. A vaccine may appear. But it remains to be seen how much more this will boost the market, as one could argue that it has already been priced into the market.

Risk premium in the stock market – the jury’s still out
For some time now, standard valuation multiples in the stock market have indicated an expensive stock market. Despite this, the stock market has risen. This may be attributed to the expected returns in the fixed-income market coinciding with falling interest rates, forcing investors to look increasingly to the stock market in their search for returns. The relative return between the fixed-income and stock markets is therefore crucial in the current climate.

The risk premium in the stock market versus the fixed income market can be calculated in various ways. One way is the so-called Fed model, where you invert the P/E ratio to get an expected return in the stock market, before deducting an expected return in the fixed-income market, e.g. sovereign  interest rates over a ten-year period. This risk premium, based on a twelve-month return on earnings, has fallen considerably. It is now well below average based on the past 10 years. There are limits to how much further it can fall. The Tower of Babel never reached heaven.

On the other hand, the risk premium based on a 24-month return on earnings is higher, somewhat above the historical average. The market usually looks more at earnings for the next 12 months than for the next two years. Therefore, more emphasis is often placed on the risk premium based on return on earnings for the next year (which is low) than on the risk premium for the next two years (which is higher). But we can’t rule out the possibility that the global pandemic may have caused market participants to focus more on earnings in 2022 and 2023 when pricing the current stock market. In which case there is room for a further upturn in the stock market. The Tower of Babel could make it to heaven after all. The jury’s still out on that one.