After an extraordinarily eventful year for financial markets and global economies, it is important to reflect on the state of the markets and the outlook for 2021. We asked Mr. David M. Darst, CFA for an update on his six-point Bear Market Checklist.
1. Is recession looming?
I don’t think so. The labor market has already staged a partial recovery as November unemployment dropped for a seventh consecutive month to 6.7% from 6.9% in October. Although this recovery appears to be slowing as restrictions on business activity have been reinstated following a surge in COVID-19 daily cases, unemployment has more than halved since its April peak of 14.7%. With the first US vaccinations outside clinical trials beginning on December 14th, restrictions could be eased again over the coming months.
There may be a slowdown, as signaled by modest annualized Q4 growth estimates due to the uptick in COVID-19 cases, but so far the economy seems to be moving along. Annualized Q3 GDP grew at an unrevised 33.1% quarter on quarter (QoQ), following a 31.7% annualized QoQ drop in Q2.
2. Is the Federal Reserve (“the Fed”) tightening?
Definitely not! In a statement last month, the Fed expressed its continued commitment to supporting the US economy through the COVID-19 pandemic. In its most recent interest rate decision, the Fed voted to maintain rates in the 0.00%-0.25% range and reiterated that it would not raise them until the labor market has recovered fully and inflation begins to run moderately above 2.0%.
However, investors would like to see the Fed explicitly state that they will buy more bonds on the long end to keep rates from rising.
In their November meeting, Fed officials discussed how they might change the program to deliver more stimulus if warranted. They will be talking more about their asset purchases (currently $120 billion monthly) at their December meeting this week, the results of which will be released on Wednesday 12/16.
3. Are spreads widening?
So far no, as spread remain very tight despite the brief blowout post-COVID.
As of the end of November, investment grade (IG) spreads tightened to 1.12% from 1.34% in October, while high-yield (HY) spreads continued to tighten to 4.33% from 5.32% in October after peaking at 10.87% in March. First-lien spreads to maturity contracted to LIBOR + 4.32% at the end of November from LIBOR + 4.66% the previous month, while second-lien spreads contracted to LIBOR + 8.16% from LIBOR + 8.72%. The yield-to-maturity of first-lien and second-lien debt remain below year end 2019 levels due to near-zero interest rates and the unprecedented Fed support for the fixed income market.
4. Is there euphoria?
Yes, this is the first yellow-red indicator of a potential bear market. The online trading platforms of Robinhood and Interactive Brokers both had outages last week, largely due to tremendous volumes from retail investors. These problems were the latest of the increasing technical issues among retail brokerages this year after cutting commissions to zero on most platforms, and as markets have rebounded rapidly after the sharp sell-off in the early days of the pandemic.
Call option buying is at record levels, which can lead to inflated implied volatility. As of this month, year-to-date equity option trading overall is 50% above last year on all options platforms. The unwind of these positions will not be pretty.
5. Are valuations excessive?
Valuations are moderately excessive, particularly by traditional metrics used by value investors like Warren Buffett.
Valuations are at a high based on price to earnings (P/E) and Shiller P/E (which uses an inflation-adjusted 10-year average earnings denominator), Buffet Indicator (Market Cap and GDP).
Following the rally in the S&P 500, last-12-months (LTM) P/Es increased from 34.6 times in October to 36.7 times in November, putting the measure in the historical 99th percentile in terms of US market capitalization to GDP, LTM P/E, and enterprise value to sales. The Shiller P/E remains at 33 times, its second highest since 1880 and just surpassing 1929, yet well below the 43 times at the peak of the dotcom bubble.
There is definitely a yellow light, but valuations have room to get more excessive. Also, the above metrics may prove to be outliers if the disconnect between COVID-impacted Q3 earnings and equity prices narrows over the next few months.
6. Are the “bodyguards” (banks, utilities, dividend-paying stocks, etc.) of the market underperforming?
No, the “bodyguards” have been doing well recently. Small stocks and value names are catching up with growth stocks, as the Russell 2000 Index (Ticker: RUT) increased 25.7% at the end of last week from the end of October, driven by the vaccine developments that have been propelling markets since early November.
Bank shares particularly, which have been the laggards among value stocks since the market rebound, rose more than 20% since October 28 as measured by the Financial Select Sector SPDR ETF (Ticker: XLF).
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