There are a few things that are undeniable in the current environment: things are challenging socially and economically, and we have had a tremendous rally off the market lows from this spring.
What types of data can we look at to help us navigate this environment? We certainly can learn from history, but we also must be patient because so much of each development in markets actually is unique. It is human responses to stresses that is usually more predictable than the future. How we, as humans, respond to surprises, is far more predictable. We tend to over-react.
First, market returns have been surprising, but so has the financial support of the Fed and the government. The Fed and fiscal response to the COVID-19 pandemic has been nothing short of enormous and expedient (by government standards). The amount of stimulus already implemented has dwarfed the response to the financial crisis of 2008. Despite some accusations in the media that there has not been swift or large enough response to the pandemic (perhaps less centered on financial support than health response), the economic support both in the US and around the world compared to the 2008 financial crisis and implementation is ongoing.
It is undeniable that the response to the COVID-19 and the recession brought about by coordinated economic stops globally is a different kind of shock. The question that looms is whether or not that warrants the view that, because support from central banks and governments has been large, the economy is fundamentally different and can support over-valued price to earnings ratios (P/E) on stocks.
Historically, independent of facts surrounding each individual recession, elevated P/E ratios have been a warning that lower future returns are likely. Another way to look at this is to examine the percentage of stock market capitalization as a percentage of National Gross Domestic Income. The idea is that when stock market prices are high relative to National Gross Domestic Income, future returns tend to be more difficult.
The timing and scenarios surrounding the “when” and “why” are not as easily seen as historical trends. I could hypothesis about all the reasons things might go right or break down and go wrong. Nobody knows for sure at this point, but careful watching is necessary at this point.
We do think that economic recovery is tied to the ongoing health crisis and responses to the pandemic. However, real challenges remain in the economy that need to be resolved. Unemployment is high, companies are looking for ways to function in a partially closed mode with varying success, congress is struggling to agree on the appropriate next set of economic stimuli, and the US is facing a major election.
While it can be tempting to interpret these things with fear and caution, a better way to look at this is to simply understand that over-reaction is likely. If things turn out better than feared, markets will probably over-react positively. If things are worse than expected, markets will probably over-react negatively.
Continuing to look at the data is imperative to make sure that information is not interpreted emotionally (a recipe for serious trouble). Understanding and being comfortable with your long-term plan is important as well because in the short-term, there is no shortage of unknowns.
Charts provided by Ned Davis Research
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