By Roman Chuyan, CFA

  • It’s one of the most expensive markets of all time, while the economy is one of the worst ever.
  • The market prices-in a quick, V-shaped recovery with certainty, forgetting about risk.

The stock market remains elevated, driven by Fed-induced liquidity and stimulus money funneled into stocks. At the same time, corporate earnings declined by around 34% in Q2 from the same quarter last year. These trends have brought valuation ratios to historical highs. In its 150-year history, Shiller’s cyclically-adjusted P/E ratio, now at 31, has only been higher in 2018 and in 1998-2002 (see chart). The 30% market plunge in the first quarter is but a blip on this chart. The valuation measure that we use in our equity model, the price-to-book ratio, is around 3.9, its highest since 2002.

The US economy shrank by 8.2% in Q2 (32.9% annualized, see chart below), and by 9.5% cumulatively in the first half of this year. This is almost double the 2008-09 Great Recession when US GDP contracted by a cumulative 5.1%, and the most severe recession in 75 years – since 1945 (cumulative -12.7%). The consensus is for the economy to cut the contraction from 9.5% to 6% for the full year. A 6% contraction in 2020 would be in the worst 4% in 140-year history of US GDP.

So, we are witnessing one of the most expensive markets of all time (using the Shiller P/E ratio), while the economy is one of the worst we have ever seen. In theory, the stock market looks forward and can see through short-term issues. However, if it had such foresight, we wouldn’t have 30-to-40% short-term rallies and selloffs. History teaches us that the market is “bipolar” – it overshoots both up and down.

So, we are witnessing one of the most expensive markets of all time (using the Shiller P/E ratio), while the economy is one of the worst we have ever seen. In theory, the stock market looks forward and can see through short-term issues. However, if it had such foresight, we wouldn’t have 30-to-40% short-term rallies and selloffs. History teaches us that the market is “bipolar” – it overshoots both up and down.

Today’s market is discounting an immediate and rapid V-shaped recovery. This is the most optimistic, best-case scenario – and there’s a chance that it, in fact, happens. But there are serious challenges to re-accelerating the economy after such a severe recession. To name just two, Congress might have created a 30-million permanent “unemployed class” that might be difficult to get back to work. Also, consumer sentiment – which typically leads spending – weakened in July and August after a bounce in June that now looks very similar to previous “early-recession bounces” – see chart above.

To be clear, I don’t know (as doesn’t anyone) the shape of the future recovery – V, L, W or whatever shape it may be. But pricing-in a V-shaped recovery with certainty seems dangerously overconfident. It’s as though market participants forgot about risk.

It is probably true that fundamentals matter less now. But the market always eventually reverts to fundamentals. To argue otherwise is to ignore the lessons of all the great bubbles. The market will likely need a catalyst in order to turn. Although no one knows how this actually happens, three candidates come to mind (so far ignored), each of which could serve as a negative catalyst: a stalemate about the second stimulus package, President Trump’s lag in the polls, and rising tensions with China.

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