Weekly Investment Commentary: With stocks at all-time highs, what could go wrong?
Highlights
- Investors continue to bid up stock prices, despite mounting evidence that the economic recovery is turning more mixed.
- With stock valuations looking lofty, a number of near-term risks could make markets vulnerable to a pullback.
- We expect supportive fiscal and monetary policy will help prolong the economic expansion, but it will be bumpy until a significant medical breakthrough helps combat the pandemic.
Equity prices rose last week, with the S&P 500 Index advancing 0.7% to hit a new record high.1 In spite of increasingly mixed economic indicators, investor sentiment was boosted by better news on the coronavirus front, indications of ongoing support from the Federal Reserve and optimism that a vaccine could be in the works. Growth and momentum led the way over value and cyclicals, reversing the trend from the previous week.1
10 observations and themes
- The economy appears to be moving from a V-shaped recovery to something more mixed. A combination of factors is casting doubt about the strength of the recovery, including school closures, new virus waves, worries over whether a new stimulus package will pass, election uncertainty and deteriorating U.S./ China relations.
- Jobs data is looking shakier. After falling for some time, new unemployment claims rose back above the one million mark last week.2
- In contrast, housing is rebounding strongly. July housing starts were at their strongest levels since 2016, and building permits experienced their strongest increase since 1990.3
- The likelihood of a new stimulus package is already baked into market expectations. That means stocks are unlikely to get a boost if a package is enacted, but could be vulnerable if no agreement is reached.
- Inflation expectations are creeping higher due to a number of factors: rising commodity prices, the falling dollar, surging money growth, tight inventories, disrupted global supply chains and rising labor costs despite high unemployment.
- Stock valuations are high, but key tailwinds remain. In particular, we think ample liquidity and highly supportive monetary and fiscal policies should continue supporting stocks. This suggests we could be due for a pullback, but that could create select buying opportunities, especially among some cyclical areas with more attractive valuations.
- Investors may have to cope with lower long-term returns. Valuations have historically been a poor measure of timing, but they have a solid track record of indicating long-term returns. And with stocks at elevated valuations, investors are likely to struggle to meet their long-term portfolio goals. This suggests selectivity will be critical in the coming decade.
- The political environment could be less market-friendly next year. Should Joe Biden capture the presidency, we would likely see higher taxes for wealthy individuals and corporations, with capital gains tax treatment being a key issue. We would also expect heightened regulatory scrutiny across the energy, financial and health care sectors.
- The U.S./China relationship is growing more hostile, and we anticipate less trade and more tension between the two countries regardless of the outcome of the U.S. elections.
- With markets at all-time highs, it’s worth looking at possible downside risks. This list of 12 possible concerns is adapted from a recent Cornerstone Macro research report:4 a coronavirus resurgence, a lack of a new fiscal deal, at-risk commercial real estate prices, rising non-performing loans, uncertain state and local government funding levels, a possible U.S. federal debt downgrade, a disputed presidential election, fractious geopolitics, emerging economies coming under pressure, a renewed U.S./China trade war, rising long-term interest rates and inflation.
Equities appear vulnerable to a near-term pullback
At this stage of the market cycle, sentiment appears mixed: Investors seem simultaneously fearful of missing out on equity rallies while being concerned about the faltering economic recovery.
In both the U.S. and in Europe, we have seen signs that areas of the economy are closing or slowing as governments and policymakers are grappling with ways to control the pandemic without a significant medical breakthrough. This suggests that the global economy remains weak, faces numerous challenges and is struggling in places where virus cases are rising.
The bottom line is that the economy is likely to face an uneven and bumpy recovery until we see a medical solution to the pandemic. Both monetary and fiscal policy will remain supportive, but the former seems to have reached its limits and the latter is expensive and prone to political difficulties.
Looking ahead, we expect supportive policy should keep the economy from sliding back into recession, but equity markets have already priced in a better outcome than we expect.
Stock prices have risen dramatically since March, pushing valuations levels to lofty levels. We are also growing concerned about technical indicators. In particular, the number of new 52-week highs is falling and market breadth is narrowing, as the rally has been driven by a relatively small number of companies.1
“Supportive policy will keep the economy from sliding back into recession, but equity markets have already priced in a better outcome than we expect.”
Over time, we think stocks should continue to make gains, but over the short-term we think markets look vulnerable to a period of consolidation or a setback.
1 Source: Bloomberg, Morningstar and FactSet
2 Source: Bureau of Labor Statistics
3 Source: Commerce Department
4 Source: Cornerstone Macro, Nancy’s Weekly Narrative, August 16, 2020
The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure the performance of the broad domestic economy. The Dow Jones Industrial Average is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq. The Nasdaq Composite is a stock market index of the common stocks and similar securities listed on the NASDAQ stock market. The Russell 2000 Index measures the performance approximately 2,000 small cap companies in the Russell 3000 Index, which is made up of 3,000 of the biggest U.S. stocks. Euro Stoxx 50 is an index of 50 of the largest and most liquid stocks of companies in the eurozone. FTSE 100 Index is a capitalization-weighted index of the 100 most highly capitalized companies traded on the London Stock Exchange. Deutsche Borse AG German Stock Index (DAX Index) is a total return index of 30 selected German blue chip stocks traded on the Frankfurt Stock Exchange. Nikkei 225 Index is a price-weighted average of 225 top-rated Japanese companies listed in the First Section of the Tokyo Stock Exchange. Hong Kong Hang Seng Index is a free-float capitalization-weighted index of selection of companies from the Stock Exchange of Hong Kong. Shanghai Stock Exchange Composite is a capitalization-weighted index that tracks the daily price performance of all A-shares and B-shares listed on the Shanghai Stock Exchange. MSCI EAFE Index is a free float-adjusted market capitalization weighted index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. Bloomberg Barclays U.S. Aggregate Bond Index covers the U.S. investment grade fixed rate bond market. The BofA Merrill Lynch 3-Month U.S. Treasury Bill Index is an unmanaged market index of U.S. Treasury securities maturing in 90 days that assumes reinvestment of all income.
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