Morgan Stanley
  • Wealth Management
  • Aug 24, 2020

What to Make of the Market’s Record Round Trip

Investors take note: The S&P 500’s recent gains may have outrun real improvements in the U.S. economy and equity fundamentals.

In mid-August, the S&P 500 completed what may be the most remarkable comeback in stock market history. After hitting a record high of 3380 on Feb. 19, then plunging 34% to a pandemic-induced low of 2237 on Mar 23, the benchmark index of the broader U.S. market took just five months to make a round trip—and set a new record of 3395.

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Does that mean the recovery stage of this new business cycle has transitioned to an expansion phase? We think not, and here are three main reasons:

  • S&P 500 gains are concentrated in a handful of stocks. The five largest names, mostly tech and social media companies, now comprise a historic 25% of the index. That group is up 30% year to date, but the median stock is down 7%. The result is an index that is not only expensive—the forward price-earnings (P/E) ratio is 23, near the extremes of the 1999 tech bubble—but also very top-heavy. Lower interest rates may seem to justify high valuations, but if inflation picks up as the recovery progresses, those rates will likely rise and create market headwinds.
  • The market seems disconnected from the economy. While markets tend to anticipate the future, expectations may be getting unrealistic. We see lots of data supporting a V-shaped recovery—with solid green shoots in housing, durable goods orders and manufacturing—but the recession isn’t over. Unemployment remains over 10%; even a 20% jump in GDP growth in the third quarter would return the economy to a level still 9% below where it stood in January. We don’t expect GDP to fully recover until the second quarter of next year and doubt that corporate profits will significantly outpace that rate. As for the market leaders, stay-at-home pandemic conditions may have pulled forward years’ worth of their future growth, rendering current investor expectations unachievable for those names.
  • Investors seem overly complacent about potential risks. Individual investors seem somewhat subdued, but institutional investors have moved to max-bullish sentiment, with put/call ratios (technical indicators based on options contracts) at seven-year lows (a low number indicates investors expect stocks to rise). Such complacency seems odd, given high uncertainty about the next phase of fiscal stimulus—now apparently on hold until after Labor Day. Although the outlook may have improved on COVID-19 infection rates and a vaccine, the pandemic’s trajectory remains in doubt. The U.S. presidential election, where possible outcomes are very much in flux, represents another major unknown for markets.

We are in a new bull market, but we urge investors to be patient and prudent right now and not chase winners.

Consider using this time to prepare tax-efficient investing strategies, such as harvesting losses to offset gains in expensive winners. We expect markets to be mostly range-bound over the next three months of uncertainty and think small caps, value-style and cyclical stocks will return to favor. Meantime, watch market breadth, valuations and economic fundamentals for signs that the market is reaching new extremes.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from Aug 24, 2020, “Implications of the Record Round Trip.” Ask your Financial Advisor for a copy or find an advisor.  Listen to the audiocast based on this report.