- Denise Chisholm's analysis of history suggests the recession is over, making it the shortest recession on record since the 1930s.
- During past recessions, stocks went up while GDP and earnings were still at a low. That can make stocks appear expensive but it may not be predictive of future growth and a rebound in earnings.
- Historically, when the market is as dislocated as it appears today, there has still been an upside for stocks. A market is dislocated when there is a large dispersion in stock valuations, expressing fear and uncertainty.
- The technology sector may continue to lead but there may also be opportunities in recovery sectors like consumer discretionary and energy.
Wondering how stocks can be up while the economy still looks dire? In an interview with Viewpoints, Fidelity's sector strategist, Denise Chisholm, offers some clues based on her extensive study of economic and stock market history.
You've said the recession is already over. What signs do you look for?
Chisholm: The National Bureau of Economic Research (NBER) defines a recession by starting with the peak in payroll employment and ending with the trough in payroll employment. According to that, a recession started as of February. We've been technically in recession for 4 months but you don't know until later, after you've seen the peak.
Now, if you look at the retail sales and payroll figures, we've seen a very strong uptick. The pickup in payroll employment that we've seen, if sustained, will likely mean that the recession is coming to an end, from a definitional standpoint.
We might be looking at a 6-month recession, which would be the shortest since the early 1930s.
That being said, every situation is different and no one knows what could happen in the future.
It doesn't feel like a recovery yet—but stocks are up quite a bit from the low. How do you explain it?
Chisholm: There is this sort of cognitive dissonance between the shape of the economic recovery and the shape of the equity market recovery. But history is littered with examples of this.
In 2009, we had a very big contraction in GDP, 4% on a year-over-year basis, which was one of the biggest declines historically. That next quarter we had a very paltry recovery, a 1% increase in GDP. In that paltry recovery, stocks were up 40%. The year after, despite the fact that it was the slowest economic recovery on record, stocks were up another 15%.
We saw the same phenomenon in 1982, where GDP contracted by 2%, but was flat for the following 2 quarters. By the time the flat period ended, stocks were back at all-time highs. They were up another 15% the year following.
So I think that cognitive dissonance is more commonplace in recessions than investors think.
Do you think the market is overpriced given earnings?
Chisholm: I think that the tricky part about calling the market overpriced is defining it by price-to-earnings (PE). If you define it that way, the market's expensive. But it's important to realize how it got that way: on an unprecedented decline in earnings.
There are 2 problems associated with using P/E. First, stocks often get more expensive at earnings troughs, but earnings troughs are often coincident with a market bottom. 2009 offers an example. On P/E, stocks got pretty cheap, at 10x, before the true earnings decline hit. But multiples quickly rebounded to 15x as the earnings decline appeared. But it was the 15x valuation level, not the 10x, that coincided with the market rally. It coincided because that was the point at which earnings rebounded.
Second, earnings multiples overall are not very predictive of future returns on a 1- or 2-year basis. If we examine quartile data on valuation, stocks have the same odds of advancing regardless of which quartile they are in.
What tends to be more predictive is the equity risk premium. (Equity risk premium is the additional return above a "risk-free" rate investors expect for putting their money into a riskier asset class.) You can proxy that as the earnings yield (the inverse of P/E) minus the 10-year Treasury yield.
On that measure you start to see differentiated probabilities—the more expensive equities are relative to bonds, the lower the odds of an equity market advance. The situation we remain in, with stocks in their cheapest quartile relative to bonds, carries the highest odds of continued performance, at 84%.
When valuation measures conflict, I tend to lean on the ones that have been more predictive historically. And those continue to point toward a market advance.
People have talked a lot about the shape of the recovery. Are we in a V-shaped recovery?
Chisholm: One of the best ways to assess what the market is discounting is by analyzing valuation spreads, the difference between the highest- and lowest-valued stocks. During volatile times, investors sell the stocks they think are risky and bid up the valuation of stocks they believe are "safe."
In March, those spreads, which I call dislocations, were within 75% of levels we saw in 2009—the highest level of fear in the market in my database. Despite the strong rally we've seen since then, those spreads are still elevated, in their top decile of the history. When market dislocations are in the top decile, meaning investors are still worried, the market has returned double its historical average, at 16%. So if history applies, current dislocations could mean more market upside.
Are there any sectors you believe are poised to outperform?
Chisholm: Technology has certainly been leadership. Consumer discretionary has joined it as leadership off the March bottom.
Many investors believe that leadership, like technology, must rotate in recessions, and will likely underperform after a significant stock market bottom. But investors would be surprised to know that during the vast majority of recessions, 1 to 3 sectors actually outperform for the 6 months prior to recession, the 6 months into that recessionary stock market trough, and the 6 months out of that recessionary stock market trough—using the NBER definition.
There have been evergreen sectors to own, so it is possible that technology, given its unique blend of relative valuation and strong fundamentals, can be sustained leadership. However, given the potential for an economic recovery, I think that an investor could barbell that with more exposed sectors like consumer discretionary and the energy sector.
(For more on sector performance, read Viewpoints on Fidelity.com: Q3 2020 sector scorecard.)