Valuation constraint: Digging a bit deeper, the forward p/e ratio on the S&P 500 now sits just under 22, based on blended forward-year earnings compiled by Bloomberg, and we haven’t seen readings that high in almost 20 years. But, earnings are clearly depressed at the moment, and it’s debatable if the market is even trading based on near-term earnings estimates anyway. If we use earnings two-years forward, the market is trading right in-line with where it did pre-COVID (in the 16-to-17 range). The question then becomes one of how temporary the current earnings hit really is. If the forecast plays out roughly as currently assumed, then stocks look to be consolidating right about where they should be.
Eye on COVID: With cases picking up across much of the developed world, there is some concern mounting that the earnings outlook will be tested again. One interesting observation is that, as much as many pundits questioned the very aggressive rally in stocks early on, much of the economic data have subsequently backed it up—especially in areas like consumer spending, housing, durable orders and trade. We know the market is always trading in a world six-to-twelve months forward, and it turns out that it was almost perfectly accurate through the spring and summer. What does it see now? Probably some choppier growth ahead as targeted lockdowns loom, but not the wide-scale shutting of the economy that we saw in the spring. As Doug and Michael note in this week’s Feature, that is probably the correct bet.
Policy: Aggressive monetary policy was a big factor that helped spur the recovery in stocks. And, while policy will remain highly accommodative, what more can the Fed really do at this point? If the market has already priced in open-ended QE and lowforever interest rates, any incremental gains from monetary policy will become much smaller. On the fiscal side, developments in Washington continue to cast support/ stimulus in doubt, and the election rhetoric (mainly about an inconclusive or contested result) opens up more uncertainty.
The Bottom Line: As surprising as it might have been to many, the equity market has more or less done what it should have done so far through the pandemic. The backdrop should remain supportive, but the next leg of the recovery is going to be tougher for the economy, and that could be just what the equity market is telling us.