As May has progressed, so has disbelief of the disconnect between equity markets and the broader economic reality that is unfolding. It’s now front page news with a variety of articles popping up detailing this dynamic (examples here, here, and here) speaking about this growing disconnect, and offering similar explanations for why this is occurring…
- The Fed – unprecedented policy response (particularly the move into corporate bonds and bond linked ETFs) coupled with the relative size of Fed’s balance sheet expansion vs other global central banks has triggered a TINA/BTD mentality in investors.
- Markets are forward looking – the market is a discounting mechanism and is looking past the lockdown related economic data towards the reopening and second derivative (rate of change) improvement in the economy/earnings moving forward.
- The winners keep winning – key large cap technology companies (FAANGM) have benefited from a WFH world and their capitalization weighted impact on markets have kept indices buoyant.
We largely agree with each of the above points at a high level. However, we offer a more nuanced view. We believe that we are in the process of resolving the interplay between forces that have shrunk left tail outcomes (policy response and continued strong performance from key portions of the “new economy”) and those that cap right tail (scientific uncertainty relating to health outcomes during reopening, behavioral impact to consumers, and emerging valuation constraints).
The Fed will support markets, it won’t become the market
A comment Jerome Powell made in his last press conference really jumped out to us. On April 29th Powell said, “The second thing I would say, you have all seen this, is when we announce these facilities, I mentioned in my remarks it’s not just the actual lending we do. We build confidence in the market, and private market participants come in, and many companies that would have had to come to the Fed have now been able to finance themselves privately, since we announced the initial term sheet on these facilities. That is a good thing.”
Confidence is returning markets to normal function. Issuance has resumed, spreads have tightened, and financial conditions are back near early-March levels. This is the communication tool writ large. It is working as intended.
This also means that two-way trading will not elicit a bazooka policy response moving forward. A system functioning normally includes episodic volatility and the Fed will not be concerned about transitory downside events (that don’t disrupt the credit creation process). The market, in our opinion, has become a bit too casual about this.
Markets are forward looking but valuation still matters
We make two points here:
- Rate of Change Reflation Needs a Low for Reference
We agree that there will be a strong second derivative recovery, but you need to establish a low from which to recover from. We have yet to establish that starting point. This is why we felt Q1 GDP (-4.8%) was worth paying attention to. The economy was operating below expectations prior to the worst of the virus. That Q2 will likely mark the absolute low for the economy is not a unique thought. However, a market move driven on second half improvements towards pre-virus trend has a higher degree of difficulty given the lower the starting point.
Historic job losses continue to play out. A surprise vs estimates in Friday’s Non-Farm Payroll release means that establishing the worst point for the labor market remains ahead of us (Fed officials are widely citing a 20% unemployment bogey in their recent communications). Without knowing the lows to improve from, how do we price second derivative potential? What if that low point is worse than we had feared? The risk we have pulled forward too much recovery is rising here.
- ’21 EPS Is Too Unclear
Even an optimistic view with no further revisions means an “expensive” market here. We have spoken of marrying technical and valuation resistance at current levels. 2930 is becoming a more formidable resistance. At current ~$163 for 2021, the one year average to 2std upside band suggests a ~2600-~2930 range. If we see further revisions, commensurate with the -25% revision evidenced in the ’20 consensus, that range drops to ~2320-~2620 (based on a $145.5 est). There are a variety of scenarios that can be worked through here but one that we believe is extremely unlikely is positive revisions to ’21. The valuation backdrop is increasingly asymmetric and limits running room from current levels in our estimation.
The Winners Will Keep Winning
This is best expressed in relative terms – our affinity for “growth,” “size” (Large > small), and US vs Row is well established. This lends itself to a structurally positive index direction given the “large bodies” these themes represent in current index construction. However, with a market that is struggling with further upside progress it is important to note that these themes are not immune to weakness in an absolute sense. If our broader index outlook proves accurate, we will enter a period where the denominator will begin to do the work (i.e. QQQ moves lower but QQQ/SPY moves higher). For long/short participants it is imperative to be paired up here. For long-only participants, the message is that weakness from here will be opportunity. These are the themes to engage with into volatility but there is no need to reach at current levels.
In sum, our high-level views remain unchanged. The market is in the process of establishing the high end of what will prove to be a wide/well-traveled range. It is increasingly likely that the highs from April 29 will define the high end while the initial downside focus remains on the key 2650 area. The market vs economy disconnect will begin to resolve and be most pronounced in an unwinding of the recent performance of economic beta with cyclicals and small caps the most vulnerable areas of the market moving forward.
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