It's been another wild ride in the markets, with the news flow being pulled in different directions. While legal challenges and recounts continue, the markets appear to have increasing clarity on the presidential race. On the other hand, we will have to wait until January to find out which party will control the Senate, and therefore, more about the potential scale and scope of a possible fiscal/monetary cocktail that could drive the economy in the years to come.
Questions about the potential scale of fiscal relief and stimulus at first put the value side of the market back on its heels, but that quickly changed last Monday with the promising news that we may be closer to a viable vaccine, and therefore, closer to the day when the economy can fully reopen. Yet at the same time, the growth of COVID cases is accelerating, which suggests that things may get worse before they get better.
The markets, being the discounting mechanism that they are, seem to be looking past concerns about current COVID trends and on to what will hopefully be better days for the economy in 2021 and 2022.
The result was a week in which the market advanced to new all-time highs amid broadening sector leadership. The chart below shows that 72% of stocks in the S&P 500 made a new 4-week high last week, matching the breadth thrust reached in early June. Breadth measures the number of stocks going up versus those going down.
A slightly different take on the breadth story is the number of stocks above their 50-day moving average (MA). For a while it looked like we might have a bearish divergence on our hands, with price reaching a new high (which the markets quickly rejected), and which was not confirmed by a new high in breadth.
But the broadening tape saved the day and we ended up with 85% of stocks above their moving average.
Back in June the breadth thrust seems to have been caused by retail day traders buying up bombed-out cyclicals, but this time it seems to be a more fundamentally based rotation from the stay-at-home stocks to the reopen stocks.
But now small-cap value stocks are catching up to large-cap growth. While value is catching up at the expense of growth on a relative basis, it is not doing so on an absolute basis. In other words, the market leadership is broadening out, which is consistent with an early cycle bull market.
Indeed, the gains since the March 23 low are consistent with the typical early cycle bull market. Equities continue to behave very much like a secular bull market: a steady uptrend intercepted by a sharp but short-lived decline, followed by a robust recovery back to new highs.
With the earnings picture looking increasingly better, valuations should start to come down in the coming months as earnings catch up to price. Typically, valuation gets ahead of the recovery as price leads earnings. Once earnings join the recovery (usually a few quarters after the price low), P/E multiples start to come down.
As for the earning cycle, forward earnings-per-share estimates continue to improve, with the 2020 estimate now at $132 (6 months ago it was close to $120) and the 2021 estimate at $163.
When I plug these earnings estimates into the discounted cash flow (DCF) model,* and using a 4% equity risk premium, I get a fair value of around 3,500 using a payout ratio of 70%, and 4,600 using a payout of 90%. In recent years the payout ratio has been around 90%, but that seems a bit ambitious to me coming right out of a downturn.
The payout ratio in the chart above is the combination of dividends and buybacks. Currently, companies are buying back shares worth around a third of their earnings. That is on the low end of the range, but consistent with the 2009–2010 cycle.
Where does the market go from here? The good news is that earnings estimates keep getting revised higher, and if the payout ratio can climb up toward 80% or so, I think there should be plenty of upside for stocks, even if there is some upward pressure on interest rates.
But the equity risk premium seems “fully priced” at these levels, so whatever upside materializes from here is likely to be the result of positive earnings revisions and/or a higher payout ratio resulting from increased share buybacks.