A recession like no other

As we enter the final quarter of this unforgettable year, the COVID-19 pandemic remains at the forefront of investor concerns. Clearly, a solution to this problem would be extremely beneficial for public health, sentiment, and global economies. However, for U.S. equity markets, such a development won’t be as sanguine.

With so much equity ownership skewed toward growth, we could see a sharp sector rotation.

If virus fears subside, markets could be volatile

Today’s equity market is considerably one-sided. Based on estimates from FundStrat, approximately 70% of the S&P 500 Index, as measured by market capitalization, consists of companies that are reasonably well positioned for the current constrained conditions. This includes high-growth, mega-cap “virus beneficiaries” in the technology sector. It also includes bond proxy stocks that are thriving in the low-interest-rate environment and would benefit from a prolonged economic slowdown. Other beneficiaries include those that are ideally suited for a pandemic, such as Clorox, or the housing sector, which is seeing a fundamental boost from the ultra-low interest rates. One example of the exuberance for growth stocks today is Tesla. The company has undoubtedly seen improvement in fundamentals. However, 2021 revenue and EPS estimates haven’t changed since 2018, yet the stock is up 10-fold since then.

Only about 30% of the market is oriented toward cyclically sensitive stocks in sectors such as industrials, financials, and consumer discretionary. So what happens if we see meaningful progress toward eliminating the virus, such as an approved vaccine or evidence of herd immunity? The consensus view is that equity markets would rally even further, but we could see disruption in the overall index averages in the equity markets — possibly in the form of a sharp sector rotation as so much of equity ownership today is skewed toward growth.

Second-quarter earnings announcements brought a scenario of ‘haves’ and 'have-nots.'

Moreover, if pandemic worries subside, investors will anticipate a sustained and robust economic recovery over the next few years. This, in turn, could lead to inflationary concerns and eventually higher interest rates, further pressuring the growth and quality sectors that are widely favored today.

Earnings extremes

Although it’s not unprecedented to see a strong stock market early in an economic downturn, we’ve seen other trends that are rare for a recessionary environment. Second-quarter earnings announcements brought a scenario of “haves” and “have-nots.” Some businesses experienced extremely strong year-over-year growth while others saw their revenues decline by staggering amounts. This contrast is unusual in the midst of a deep recession, when typically most businesses struggle to varying degrees. Obviously, leisure-related industries, such as hotels, casinos, airlines, cruise lines, and concert venues have been hit hard. But auto parts and home improvement retailers have experienced phenomenal results. Lowe’s, for example, reported same-store sales growth of an astounding 34% in the most recent quarter. Also, construction activity has rebounded meaningfully, and U.S. pending home sales have skyrocketed. Many of these trends are the result of pandemic-related shifts in business practices and consumer behavior as well as ultra-low interest rates, making this a recession like no other in history.

Multiples and interest rates: A vulnerable equity market?

Also worth noting in today’s market are rapidly expanding price/earnings multiples. The adage that “stock prices follow earnings” seems true only in terms of direction but not at all in magnitude. Apple’s stock price, for example, has soared fourfold in the past four years, yet earnings have increased just 50%. And over the past five years, the company’s compounded annual revenue growth has been less than 4% per year. Apple’s P/E multiple has expanded from 13 times 2016 forward earnings to a record 34x today.

Many factors could be contributing to Apple’s multiple expansion, such as an appreciation for the company’s resilience and pent-up earnings potential given the challenging 2020 environment. However, another key driver is the low-interest-rate environment spurred by a hyper-accommodative Federal Reserve. This drives investors to equities from low-yielding bonds — Apple’s dividend yield is in line with the 10-year Treasury — and it increases the present value of future growth through a lower discount rate.

This represents a key risk for the equity market. If interest rates rise, P/E multiples are more likely to contract. High-growth stocks would be particularly vulnerable, as their elevated multiples have the farthest to compress. Since the global financial crisis, each time rates moved higher, equity market volatility intensified. Many investors remember the 2013 “Taper Tantrum,” when emerging market stocks corrected.

The equity market has benefited from low inflation expectations and no deflation, which is a near-perfect Goldilocks scenario. If we were to move out of this range and inflationary pressures increase, especially if the economy gains strength, we could see rising interest rates — a risk we are monitoring in the closing months of 2020.

Share prices are outpacing earnings