Once Again, I Am (Apparently) Missing Something?

We own stocks and equity ETF's in our High Rock Private Client portfolios for long-term growth with capital appreciation and dividend income. So we naturally expect that, in time,  higher stock prices (as a larger group) will give us returns that grow our money. When stock prices rise and portfolio values grow, we (and our clients who check regularly) are happy. We have a natural desire to see this working. 

When it happens outside the realm of reality, it frightens us, because it sets up a greater potential for near-term disappointment and we know that when investors become disappointed and / or frightened, their patience for waiting for the long-term runs a little thin. The last thing we want is for our clients to abandon their long-term plans because they get scared out of their investments in the equity market.

One of the fundamentals around stock ownership (among a number of other valuation metrics) is based on earnings expectations relative to the price of the stock. We call this the forward price to earnings (P/E) ratio (chart above). 

When stocks are cheap (representing value), the P/E ratio falls as it did in 2008 to below 9. As the P/E ratio rises, it signals that stocks are getting expensive. It peaked at 19 in late January / early February (highest level since the financial crisis) as stock prices made new highs while earnings expectations were falling. 

For us, that period (Oct. 2019 to Jan. 2020) signaled that there was way too much risk attached to owning equity assets. When the coronavirus pandemic began, P/E ratios fell to a relatively attractive 13. Last week  P/E's jumped to about 17.5. as stock prices rose and earnings forecasts plunged.

Why do stock prices rise if the fundamentals are not strong enough to support those prices? 

There are lots of varied opinions on that topic, but the more positive stock trader / investor / advisor / cheerleader looks to the central banks to be the back-stop if stock markets should go into sell mode, thereby providing a floor for stock prices. We saw it as the U.S. Federal Reserve provided QE through the 2009 to 2015 period and again in early 2019 by cutting interest rates.

With the sudden shock to the global economy provided by the coronavirus and the efforts to curtail it, central banks have once again become the stock market support system.

The end result is a stock market that is further removed from its underlying fundamentals: earnings expectations are plummeting, while stock prices are rising (or no longer falling, depending on your context). That distortion (of reality) means there is increased risk inherent in the ownership of the equity market asset class. Risk of another seriously nerve-wracking decline.

The economic news is grim. If you have not seen the Bank of Canada's Monetary Policy Report released yesterday, you may want to have a look, it is not pretty, but it is the current reality:

"Measures required to control the spread of COVID-19 have caused a severe reduction in economic activity. The sudden closure of many businesses and the sharp fall in trade have prompted major disruptions to global supply chains. The resulting increase in unemployment has been unprecedented and has contributed to a drop in income. This, combined with elevated indebtedness and the abrupt deterioration in business and household confidence, is weighing heavily on a wide range of economic activities. A sharp contraction in the global economy in the first half of the year is unavoidable."

And we know, from it's past economic reports, that the Bank of Canada tends to paint a more positive perspective of the outlook so as to not frighten the general population too much.

Our friend, economist, strategist and great critical thinker David Rosenberg (of Rosenberg Research) had this to say:

"The market bulls have been saying for a while now that the stimulus from the government is going to stop this recession in its tracks, a recession that had already been priced in, and now time to price in the recovery. Or at least, look through the downturn and focus on "normalized" earnings. From my lens, it is tough to identify what is "normalized" when the future will be anything but "normal"."

What will be the "new" normal? Financially and economically speaking, a very long path to get consumers and businesses back to a level where they are able to generate enough income to comfortably re-start spending and hiring. 

Don't forget that all this current government spending will eventually have to be paid for. Initially governments will have to issue bonds to cover the payouts, more bonds could push longer term interest rates higher.

To finance the debt and deficits look out for tax increases. 

With all the fiscal and monetary stimulus, any recovery could be fraught with inflationary pressures.

The "new" normal will be significantly different than whatever we had when we entered the 20's (all those roaring 20's New Years Eve party's that the millennials got up to might have been a bit of an omen).

In the "new" normal what will be the evolution of any party? dancing / contact? concerts? sporting events? Will we need to present our certificates of COVID-19 testing and vaccination?

Lots to speculate on, but certainly not anything that we might have expected as we began the year.

Time to manage our expectations about the future. Including our investments. I am cautiously optimistic that we will find our way, but don't fall in with the camp selling a quick bounce-back solution.