Investors may be wondering if stocks are too expensive, given their massive rally from the market bottom amid grim data. We think stocks are closer to their fair value because low interest rates can sustain higher valuations, low expectations allow for an upside surprise, and extensive stimulus measures are counteracting effects of a temporary shock.
There’s a popular narrative at the moment that stocks are outrageously expensive because we’ve had a massive rally from the bottom and the economic and the earnings data are really, really bad at the moment. So it’s easy to think that the stock market has gotten ahead of itself.
However, I would argue that stocks are closer to fairly valued. Let me give three reasons. First, interest rates. Second, expectations. And third, the stimulus measures.
On interest rates, we started the year 1.9% on the US 10-year treasury, and now, we’re below .9%, so we’re 100 basis points lower. All else being equal, valuation models tell us that when rates drop, we can sustain higher valuations.
On expectations, I would argue that expectations are low. You see this in sentiment indicators, for example. This is not a rally that is well liked. CFTC net speculative positions, so hedge funds for example, are showing massively short positions.
Also, another piece of evidence that expectations are fairly low is that, unlike prior stock market recoveries, value stocks, small cap stocks, emerging markets stocks, haven’t rallied really hard up until very, very recently. In fact, those three indices, small cap stocks, value stocks, emerging markets stocks, are all still down 9% year to date.
So this lack of rotation into more cyclical asset classes within stock markets shows that expectations are still fairly low. One way to think about expectations is that suppose that everyone expects that the economy will open at 20% for the next eight to 12 months, and that we actually reopen at 50% sooner rather than later. This will cause positive surprises in a lot of the underlying data.
On the size of the stimulus, this has been massive, more than twice the size of the stimulus for the 2008-2009 crisis plus the QEs 1, 2 and three. So this gives you an idea of the magnitude of both fiscal and monetary stimulus measures that have been deployed globally, in the context of what is fundamentally a temporary shock.
And when I say that I don’t mean that the economy will recover very quickly or that we won’t see any permanent damage. But fundamentally, once we get a vaccine and the pandemic gets under control, we have a lot of jobs that will return almost automatically in the restaurant industry, in the leisure and hospitality industries. So massive stimulus, a bridge for what is fundamentally a temporary shock despite some permanent damage.
So investors should think about their asset allocation especially from a long-term perspective, as, look, now is not the time to be a hero and being well diversified between stocks and bonds when we think there are still risks, for example, the U.S. election around stocks. It makes sense to be strategically well diversified across stocks and bond markets.