Does valuation matter right now?
The market’s V-shaped recovery since March has been the most powerful on record. Fiscal and monetary action has worked, and has moved investors off the sidelines and back into risk assets. Some of the massive cash hoard built at the beginning of the COVID crisis has been deployed, but we believe there is a significant amount still on the sidelines. In addition, fixed income future returns look paltry and we could see a significant shift out of this asset class into riskier investments.
With the proliferation of program trading and market-weighted ETF’s, it appears as if valuation is off the table as a limiting factor for stocks. We have been bemused by how analysts revise price targets upward without any real fundamental analysis supporting their revisions. Forward PE’s have expanded to levels not seen since the dot com boom. Some of this is deserved for companies that are riding the shift to the new (digital) economy and seeing increasing revenue and earnings, while for others it’s only price expansion without earnings growth. Speculation, as mentioned in a previous update, is almost as casino-like as we have ever witnessed (aside from perhaps the dot com years, the Roaring 20’s or the “tulip mania” of the 1600’s.)
In addition, the market is now clearly discounting a successful vaccine and a fairly quick return back to economic boom times. Major areas of market risk we have identified, including China trade tension, the election, and a second wave of coronavirus, have all melted in the face of unrelenting government intervention. When that train stops, or at least takes a break, depends on whether any of these risk factors intensifies, or we see a reversal in fiscal and monetary accommodation. Valuation alone will not stall this impressive rally.
Which one of these risk factors could move to the forefront and knock this market off its pedestal? China is taking a very passive stance on our hawkish trade policies and will probably continue that tactic until the election. A second wave of COVID may already be happening, but the likelihood of a vaccine is keeping that risk at bay. That leaves us with election risk, and the policies likely to be impacted by a change of administration as the most likely disruptor. Even this uncertainty could be short lived as there are pros and cons to a changeover, as we have witnessed in the last eight elections. If history is our guide, the best result would be divided government and there is still a high probability that we will see that.
Where to find new investment ideas amid the current euphoria coupled with election overhang has been a major part of our focus. There are clear industries and individual companies that will win either way. These include infrastructure, 5G communications, alternative energy, other selective technologies, utilities, and consumer staples. We also believe gold is a clear winner under most scenarios as well. The “value trade” is interesting and we may selectively find some interesting ideas there, but it has been a trap the last six years, so we will tread lightly. Whatever happens in November, it’s clear that deficit spending will continue and low rates are here for a while. Eventually something has to give between these two strange bedfellows but we are living in the new normal…for now.
Please let me know if you have any questions via phone at 804-774-2087 or email at Jesse.Ellington@middleburgfinancial.com.
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