The equity markets have been on a drive over the past 3 weeks, being boosted by fiscal and monetary support. Since the 23rd of March, the market has rallied over 26% as optimism begins to flood these risk-on assets. The S&P 500 is now sitting right above the 50% point between its February highs and the end of March lows.
Why The Optimism?
A lot of analysts and investors are writing off 2020 earnings and looking toward 2021. The Federal Reserve’s unprecedented monetary measures have set up a tightly wound springboard for the economy to boom off of once business can resume in a quasi-normal fashion. This is the reason for my long-term optimism about the US economy.
Now some of the big institutional investors are saying that the worst is behind us, and with this government backing, we will likely not test our March lows. The government money that is going to flood our economy in the short run has likely increased equities’ support levels, but that does not mean that a pullback isn’t on the horizon.
Many investment decisions are now being made off of the virus’s data trends like new case rates, deaths, and hospitalized cases. All of these trend lines have appeared to level off, which is stimulating even more optimism in the stock market. These figures only point to the fact that the self-quarantine is working. We have no idea if another pandemic wave will hit when the economy opens up again, which would be the worst-case scenario.
I think we are on a “positive headline high,” and we shouldn’t try to chase this rally. Patience is the virtue of a successful investor. Buying at this 5-week high would not be the most favorable investment decision considering the amount of volatility and uncertainty we are experiencing.
Why I’m Not As Optimistic?
In my opinion, equities have been pushed to a premium over the past couple of weeks. If we consider the inherent risk that the markets will be facing with the progressing pandemic over an unknowable timeline, there is no way to know what the long-term economic impact will be.
Getting businesses back to a new normal is now the goal, and the only way to do this in the short-term is by testing. Not only testing for the virus but testing for the antibodies which would deem individuals safe from contracting the disease. Currently, less than 1% of the US population has been tested for this disease, and antibody testing is just now starting. We will need to test on a massive scale for both the virus and the antibodies, for society and the economy to feel safe. This process will take months.
For things to truly go back to normal, we will need a treatment or vaccine, which is not anticipated to be widely available for at least another 12-months at the absolute earliest.
Another reason for my short-term pessimism about current equity prices is the denominator in our valuations. When deciding whether the broader market is relatively ‘cheap,’ ‘expensive,’ or fairly priced, investors use the industry-standard price-to-earnings ratio (P/E). Right now, earnings (the ratio’s denominator) for the next 12 months couldn’t be more uncertain and is likely even lower than what conservative analysts are forecasting.
Some analysts are speculating that current forward P/E levels are higher than they were at our highs in February, considering how much earnings are expected to decline in 2020.
Demand has seemingly halted across almost every sector of the US economy (with those few outliers) and this will continue the longer the economy is shutdown. The government support is softening some of the blow, but not all of it. It may not be able to sustain its level of spending/lending for any extended period of time.
Bankruptcies are likely to start hitting the more this economic shutdown is prolonged.
Companies like Six Flags (SIX - Free Report) and Carnival (CCL - Free Report) are going to hold a stigma for years following this pandemic even if their deteriorating balance sheets can stay afloat amid this pandemic, during what is supposed to be their peak season.
The already declining department store space is on the brink of bankruptcy with Macy’s (M - Free Report) and JC Penney JCP seeing plummeting share prices and credit ratings that slip further into junk bond territory. These antiquated business models can’t shine a light to ecommerce giants like Amazon (AMZN - Free Report) , who hit all-time-highs today.
What I Am Doing
I am being patient and holding cash for the next leg down. I think we are trading at relatively rich valuations considering the circumstances. I have been buying a few S&P 500 tracking ETF (SPY - Free Report) puts to hedge some of my risk. Selling covered calls would also be a good strategy amid this uncertainty, capturing some of the high volatility premiums they are offering.
With the Fed propping up the stock market with its history-making monetary support, I am now going back to the strategy that investors have been following for the past decade prior, buying the dips. I think we are due for a rather large dip in the next month or so considering the run-up we’ve seen and am looking for the S&P 500 to fall back to 2,650 or roughly 10%. This is the level that I will start buying some of my favorite stocks at.
I think tech is going to be the big winner coming out of this downturn, and I am looking to buy robust blue-chip names like Microsoft (MSFT - Free Report) , Alibaba (BABA - Free Report) , Adobe (ADBE - Free Report) , and Nvidia (NVDA - Free Report) .
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