Analyzing US equity market peaks
US stock markets at record highs
The S&P 500 share index has gained around 50% from its 23 March low of 2237, although the sharpest appreciation was already realized by June.
- The Nasdaq index has shown even stronger performance: from its pre-COVID-19 peak of 9818 in mid-February; it fell to a low of 6861 on 23 March, but now stands at 11665, a year high.
- European indices are performing less strongly: the Eurostoxx 50 stands at 3344.3, versus its February peak of 3834.
- The SSE composite index (Shanghai) reached a 2020 peak at 3451 on 9 July, versus its March low of 2661. It is in positive territory for 2020, unlike the European index.
- According to Reuters, global equity valuations gained USD24 trillion since March in aggregate.
Outpacing the real economy?
The rally - particularly in the US - appears to have outpaced aggregate developments in the real economy.
- Although major economies have increased activity sharply from coronavirus disease 2019 (COVID-19) virus-related lows, severe GDP declines have been recorded in the second quarter and major uncertainties remain over the course and duration of the pandemic.
- Reported earnings in the US have not regained their pre-pandemic levels and appear fragile.
- Many firms continue to face severe or acute business challenges, in many cases potentially threatening their survival.
- Given the loss of production and reduction in near-term profitability, plus the issuance of record amounts of corporate debt, at first sight valuations appear paradoxical.
Key drivers
While we cannot comment on individual investment decisions, we can identify the following key drivers:
- Financial market distortions stemming from monetary and fiscal policy support.
- Business paradigm changes, particularly favoring new technologies/ healthcare.
- Banking sector and energy underperformance.
Large-scale monetary easing (QE) and fiscal expansion has provided a clear boost to financial sector valuations, leading to price levels in debt and equity securities that appear disconnected from real economic developments.
- Italian 10-year government bonds have traded recently at under 1% yield and now stand at 1.07%, despite a debt to GDP ratio for the country predicted to reach levels normally associated with debt stress.
- High yield bond yields, which traded at over 11% in April, have traded down to less than half these levels despite poor underlying fundamentals.
- We have also highlighted bond sales by such countries as Belarus, Bahrain, Egypt and El Salvador as indicative of very strong financial risk appetite.
- We assess that both debt and equity markets are being skewed by policy impacts, with multiple debt market indicators of policy skew towards potentially excessive risk appetite given constrained returns.
A second key driver is the change in business paradigms, especially favoring new technologies.
- Stock market performance both between and within indices is far from uniform.
- Among the strongest performers are large companies in the technology sector.
- A stand-out example is Apple. On 18 August, its valuation rose to over USD2 trillion for the first time, the first firm to reach this milestone. By 26 August, this reached USD2.16 trillion.
- Having taken 42 years to reach a USD1-trillion valuation in 2018, and having fallen under this level in March, it has gained over USD1 trillion in stock market valuation in the last five months.
- The five largest US technology firms: Apple, Microsoft, Amazon, Alphabet and Facebook, have gained almost USD3 trillion in value since March, with S&P Global Ratings (S&P) flagging that their combined gains are almost equal to those achieved by the S&P 500's 50 next most valuable companies combined. Visa and Alphabet have also achieved record low issuance costs for seven- and 10-year debt respectively.
Another area of positive focus has been healthcare, where valuations also have surged given greater outlays relating to the COVID-19 virus, but also given wider focus on healthcare systems and needs, and the benefits of new medical developments.
The strong appetite in the technology and healthcare sector recently was further indicated by exceptional performances in the primary equity markets: within the week to 14 August.
- Chinese real estate firm KE Holdings - which has a large electronic platform as well as physical networks ended first-day trading on 13 August with an 87% gain, the largest appreciation for a billion-dollar IPO in two decades.
- Even more spectacular appreciation was recorded by Curevac, a German vaccines company. The firm enjoyed a 249% appreciation on first day trading, closing on Nasdaq on 14 August at USD55.80 per share versus a USD16 issue price.
Banking stocks are underperforming
- From 3833 on 2 January, the FTSE 350 bank index now stands at just 2025.
- Many major banks are trading at a modest fraction of historical book valuations, with market participants expecting heavy new impairment to emerge once financial loan moratoriums end.
- A large PB discount implies that investors deem book asset valuations either to be inflated or to have undergone meaningful deterioration since last valued: a discount is also indicative of a bank being viewed as likely to undergo structural change, with asset disposals and write-downs likely.
- Over time, losses on corporate and household lending are expected to hurt already low bank profitability - which is particularly weak in Europe - with increased provisioning requirements pushing many banks into loss, and potentially cutting into the sector's generally adequate capital buffers.
- Bank shares are further hurt by regulatory pressure to curtail dividends and buybacks.
- While we do not expect a full-scale banking crisis as in 2008-09, sector capital needs are likely to expand sharply in the coming years, and some banks and weaker systems may yet require state rescue.
Uneven performance
An uneven pattern of performance spans the wider S&P index:
- According to the Financial Times (FT), one-fifth of S&P 500 companies were trading on 21 August at more than 50% below their peak values.
- The same source cited Cornerstone Macro data suggesting that the average member of the index was 28.4% below its peak.
- Technology shares were up 27% in 2020, and those in consumer discretionary activities by 23 percent,
- Conversely, from a base of 19 February valuations, energy stocks were the worst performing in the index, down by 34.2%, followed by financials with a 21.6% loss.
- Industrials, real estate and utilities were down by 9.3%, 13.3% and 15.5% respectively.
- Even in outperforming sectors performance divergence is very strong. Within the consumer area, as an example cited by the FT, Amazon (which has a 43% weighting in the sector's index presence) had appreciated 78% in 2020, while Carnival (cruise line) and Ralph Lauren have fallen by over 40%.
Outlook and implications
Financial markets do contain elements of valuation detached from underlying economic reality, clearly indicated by the rapid fall in junk bond returns, and the market's acceptance of riskier credits for long duration. Several European countries with strained and rapidly deteriorating debt fundamentals are trading at historically low yield levels in response to policy actions.
However, there has also been a paradigm shift affecting equity valuations. In many areas, progress with new technology has been rapidly accelerated by the COVID-19 virus pandemic, and in some areas consumer conduct appears unlikely to revert fully to prior conduct. A small number of major technology firms have played a disproportionate role in driving the S&P 500 higher, and its technology orientation also helps to explain Nasdaq's outperformance.
Conversely, Europe's lagging performance suggests that investors are sensitive to the region's adverse fundamentals - such as ageing demographics as well as heavy debt burdens.
Given adverse pending fundamentals, banking shares stand out for their underperformance and the challenging prospects ahead, with energy also underperforming.
Overall, the equity market rally is far from uniform, with many companies still experiencing sizeable valuation losses, while technology-oriented firms stand out for their relative appreciation.