Crisis stimulus finds nest in shares

The effects of massive monetary easing happening across the globe is coming home to roost in stock markets, including our own. Be cautious.

By Simon Brown

After collapsing in March, markets locally and globally have rallied. The Nasdaq has led the way to near all-time highs while the S&P 500 is back above 3 100, close to its record high of 3 386. Both indices reached record highs in February.

Locally, the FTSE/JSE Top 40 Index is trading just below 49 000, at the time of writing, after kicking the year off at 51 500. The all-time high for the Top 40 was just under 54 000 in November 2017.

Looking at these indices’ levels, it’s fair to ask: what pandemic? Valuations are stretched to record levels.

The forward price-to-earnings ratio (P/E) of the S&P 500 is the most expensive it has ever been, with two exceptions: the 2001 dotcom boom and the 2008 crisis. The former ended in years of gloom, while the latter led to the longest and strongest bull market in the history of US markets on the back of US Federal Reserve (Fed) stimulus.

A P/E is historic. It takes the current share or index price and divides the latest annual earnings into that level to determine the value. A forward P/E uses the expected earnings for the year ahead, dividing that into the current price. The forward P/E is a better gauge of value, but also harder as we need to try and work out what the next year’s earnings will be.

For the S&P 500 the current historic P/E is 22.4 times – that’s already an all-time high aside from 2008 and 2001. But what will earnings be for the year ahead? Will it be 20% lower at a minimum? Then we can adjust that historic P/E upwards by 20%, getting us to a forward P/E of at least 26.9 times. Locally, the current Top 40 P/E is 16.1 times and a 20% reduction in earnings pushes it to 19.3 times. Not as bad as the S&P 500, but still expensive. But 20% lower earnings are probably a best-case scenario and

things could be worse. There is, however, a simple explanation for this: the stimulus packages announced and implemented by governments across the world, most notably by the Fed. In much the same way as after the 2008/09 global financial crisis, central banks are pumping money into the system to create liquidity and keep markets afloat. This puts massive amounts of cash into the system and with low interest rates that cash finds itself a home in the stock market. This initially started in the US, but we’re now seeing it move into emerging markets such as our own.

A market watcher may think this is crazy and that all-time highs and stretched valuations during a pandemic are insane. But an old lesson is “don’t fight the Fed”. When they come to the rescue with guns blazing, nobody can stand in the way and markets will rally. But we also need to consider that the market is implying the worst is behind us and the purchasing managers index data for May certainly shows a strong bounce from the record low April levels – albeit the index is still below the level of 50, thus indicating a contraction.

We can shake our heads in disbelief, but we can’t win this fight and so I continue with my monthly purchases of ETFs as I always do. But I remain very cautious of individual shares, rather waiting to see some results that include pandemic trading conditions so as to get a clearer picture. It does mean I am missing some upside action, but I am also sleeping better at night by not just jumping into the fray.

There will be post-pandemic winners (tech stocks) and losers (leisure counters) and some of those are easy to spot, but many will surprise us, so caution remains the name of the game. ■

editorial@finweek.co.za