Despite facing a myriad of problems equity markets have staged a stunning comeback rally over the last three months. Liquidity from central banks, combined with massive rescue packages from governments, have together kept markets afloat. But the scale and ferocity of the rally has many investors questioning its sustainability. Valuations are at or close to all-time highs, just as regions around the world reinstate restrictions in the face of a second wave of infections.

So have equity markets gotten ahead of themselves? Or are we just facing another bump in the road to recovery? I recently reached out to three contributors to get their take. Responses come from Emanuel Datt, Datt Capital; Aaron Binstead, Lazard Asset Management; and Roger Montgomery, Montgomery Investment Management.

There is no alternative

Emanuel Datt, Datt Capital

One thing I have learnt over time is that markets are always in flux and sensitive to economic and political conditions. Early on in the year, virtually no one could have predicted the extent of the economic shock that was a direct result of government intervention in restricting social movement and interaction within our society. The government’s ‘blunt instrument’ approach is almost entirely responsible for the economic slowdown and difficult social conditions we find ourselves in. Whilst the government has provided significant assistance to many affected; the reality is that the livelihoods of small business owners, many in the tourism and hospitality industries, has been destroyed with little hope of revival. This destruction of a portion of the middle class and lack of capital formation is a worrying sign for us when looking forward.

The government support from this crisis must be paid for eventually and we anticipate there will be significant tax increases or levies to balance the governments books. Accordingly, we are negative on the general economic environment with significant flow on effects yet to be seen. Despite this somewhat glum outlook, we consider that humans will always do what is necessary to survive and thrive, and this colours our own investment decisions.

At present, the returns on offer in more conservative asset classes like fixed income are little to non-existent in real terms. Accordingly, given the paucity of investable asset classes we expect the equity markets to continue their march up over time as more investors are driven to the stock markets in a hunt of real returns. 

Whilst markets cannot increase nor diverge from economic conditions forever, we believe over the near-term there is still likely to be further upside in equity markets.

Watch out for the end of stimulus

Aaron Binsted, Lazard Asset Management

Historic market cycles have displayed sharp bounces after large falls. Markets also typically run in response to large monetary and fiscal stimulus and we currently have quantities of both. While the last six months have been volatile, we believe that it is more normal than you may expect. As to how long this rally may last, we do not have a strong opinion. We are valuation investors and as a result, leave shorter-term technical predictions to others.

What we can say is that the Australian share market is currently on the highest two-year forward EPS multiple in fifteen years. Those forecasts incorporate a significant recovery from the current crisis and arguably do not fully account for some future air pockets. Let us provide one example.

Consumer incomes and company earnings are currently receiving a significant amount of support. Even if the current Government programs are rolled out past September, we expect that they are going to reduce in size. To think about how this may play out we can look back at the last large-scale stimulus measures we saw in the wake of the Global Financial Crisis (GFC). In February 2009, Kevin Rudd announced his ‘cheques to households’. Discretionary stocks bounced hard in response. As a result, JB Hi-fi tripled and Harvey Norman doubled in price by November 2009.

Over the next two years however, as the stimulus dried up, JB Hi-fi halved and Harvey Norman fell by approximately 60%. It is worth noting that the size of the stimulus is much larger today than during the GFC and we expect there to be higher levels of unemployment by the end of the COVID-19 period. While we have used JB Hi-fi and Harvey Norman as examples, in our view, this dynamic is relevant for a large portion of the Australian market.

That being said, we are very comfortable with the portfolio we have today. The stocks we own are trading at attractive valuations, have solid balance sheets and are not dependent on stimulus. Due to the high and increasing valuation dispersion, with the market narrowly chasing past winners, there are companies with a promising outlook trading at attractive prices.

The markets are not the economy

Roger Montgomery, Montgomery Investment Management

It’s important to point out that there is no correlation between markets and the economy in any single year. Many years ago, a friend and peer collated global economic growth data and stock market performance data. For every country considered, when the economy grew faster than its average in any given year, 50 per cent of the time the stock market performed better than its average and 50 per cent of the time it was worse. Similarly, in any year where the economy grew at a rate lower than average, the market did better than average half the time and worse half the time. This effect was observable across all economies and stock markets.

Having said that, markets are moved by surprises. The question is not whether the global, US or Australian economy is in a recession. The question is whether the current nature of the economic outlook is likely to produce positive or negative surprises.

If you had asked me a month ago whether COVID-19 had the capacity to surprise, I would have said that ability was over. But with conditions in the US, UK and just about all emerging jurisdictions worsening, the impact of COVID-19 on economies and businesses still has the capacity to adversely surprise.

Data showing a rapidly rising US infection rate and weekly global case rates hitting a million people per week demonstrates the battle against the virus is far from over.

Recently, Qantas fired a shot over the bough of speculators who believe in fast and easy economic recoveries. Its announcement, while burning through A$40 million dollars per week, confirms that a global return to 2019 levels of economic activity cannot occur for some years. Qantas announced staff cuts of 6000 people, mostly in international operations. It also confirmed that a further 15,000 people will remain stood down and 100 aircraft will be grounded for 12 months.

More important is what the announcement implies for the economy. Job losses are running at unprecedented levels across the economy.

The currently-elevated levels of consumer confidence are therefore likely to reflect the temporary support of JobKeeper payments in Australia, and the various forms of helicopter money elsewhere in the world. In Australia at least, these support programs will end and when they do, there will be fewer jobs for people to return to. Consequently, spending is likely to collapse again.

With the possibility of a more protracted recession looming, it is incongruous that the stock market, in aggregate, is so expensive. The Price to Earnings (PE) ratio for the Australian and US markets is now at or nearing record highs. This is an extraordinary outcome whenever it transpires but especially when both countries are in a recession.

Prices cannot remain disengaged from the present value of future cash flows for long and sentiment can shift overnight. Without warning today’s treasure can become tomorrow’s trash.

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Robert Delforce

Great insight and contribution to debate as always, ROGER!!! As a conceptual economist it always intrigues me how so much contemporary commentary/debate gets so anchored on if-when-how-much market prices will RETURN TO and EXCEED pre-COVID-19 levels ...Whereas the real focus of analysis and debate moving forward is WHETHER those pre-March 23, 2020 prices were justifiable/realistic on forward-earnings in the first place? ** Were they sustainable....or simply manifestations of fanciful wish-thinking? and **If they were sustainable, then are they STILL sustainable in the new COVID-19 WORLD??????? The if-when-how-much question IS however mighty relevant to those who bought in at the March 23-27 2020 prices and are now contemplating in the subsequent market recovery exiting those positions [or at least taking $$s off the table]. My own response then was to buy selected gold stocks on my watch list or already in my portfolio at the time. The plays have increased between 75 and 207% and I've either exited or significantly deleveraged my exposures. The buying was logical and based on a stock holding/watchlist compiled PRE-COVID-19 but, of course, totally unrelated to any "Planet-Mars" crystal ball-FORESEEING of COVID-19. The sell play in contrast was just risk management consistent with my underlying risk-return function and was HIGHLY SUBJECTIVE as I believe that only the deluded can think they can accurately predict the where-to of the next 12-18 months!! ....Great thought-provoking article as always, Patrick...and much appreciation to Emanuel, Aaron and Roger for their thoughts/deliberations!!