Stocks continued their march higher into 2021. Vaccine rollout progress may be the most important data point to watch over the next few months. Investor sentiment has been elevated since pharmaceutical companies announced successful trials, and consequently, stocks have climbed near record highs on optimism regarding a vaccine-led economic recovery. While stimulus liquidity and sentiment have been steering returns, company earnings are also gearing up to show us where we are in our fundamental recovery.
It was the father of value investing, Benjamin Graham, that gave us the concept of the stock market as a voting machine in the short run and a weighing machine in the long run. Meaning? Stocks can rise and fall quickly on popularity and sentiment, but sustainable performance is due to weighty fundamental factors like earnings, cash flow, and valuations.
In today’s environment, what is driving sentiment, and how are the fundamentals?
What is driving sentiment?
This one is fairly simple. Vaccine rollout and economic reopening are currently the primary drivers of investor sentiment. On November 9th, Pfizer and BioNTech announced that their vaccine was more than 90% effective in trials. Since that announcement, the S&P 500 index is up more than 10%, and the Russell 2000 index (U.S. small companies) is up more than 30%. Small caps have experienced a trifecta of sentiment boosts: 1) small companies and their sector/industry composition made them more sensitive to pandemic shutdowns and, conversely, reopenings; 2) small companies are also more likely to benefit from additional stimulus and direct aid provided by the Biden administration and a Democratic-controlled Congress; and 3) small companies typically display more growth and returns in early-stage economic expansions.
The areas of the economy that are lagging and stand to benefit the most from a vaccine are airlines, hospitality & leisure, commercial real estate, energy, banks, and brick & mortar retailers. The hospitality industry has been impacted particularly hard. In December, the latest wave of COVID-19 infections and resulting restrictions led to a loss of 498,000 jobs in the hospitality industry, with 372,000 of those losses from restaurants and bars. Since February 2020, the hospitality industry has had a net loss of 3.9 million jobs.
So, how is the rollout going? There are a couple of good tracking sites that I have seen. Bloomberg’s site reports 19.8 million cumulative doses administered across the U.S. and a daily average of 982,739 doses over the last week. COVID-19 Vaccine Projections has several data charts including 1st and 2nd doses administered. They also use the data to project a path to herd immunity using vaccinations and estimated infections (antibodies). The current path of the projection places the estimate of herd immunity in mid-July.
On a positive note, recent data shows that COVID-19 cases and hospitalizations have been decreasing nationally and in each of the U.S. regions. COVID-19 testing remains high, while the rolling 7-day average of cases peaked at 246,321 on January 11th and sits at 179,536 on January 22nd. Hospitalizations peaked at 131,127 on January 12th and sit at 122,444 on January 22nd.
Sentiment investing does have downsides. A quick turn on potential bad news or damage to the sources of optimistic sentiment is a main concern. Vaccine rollout needs to go smoothly. Vaccines need to protect from mutations of the coronavirus or deliver us to herd immunity before mutations spread widely.
Another downside is irrational exuberance. Tesla and Bitcoin are up 643% and 279% respectively over the trailing year. GameStop was up 51% on Friday, and trading halted at one point after a group of traders from a Reddit.com forum pumped the stock to squeeze out a short trader. Newly listed companies raised $155 billion from 471 initial public offerings in 2020, a level not seen since 1999. The U.S. IPO Index also returned 107% in 2020. ????
How are the fundamentals?
The primary fundamental driver of stock market performance over long periods is corporate earnings – a weighing machine. Valuations using the traditional forward price-to-earnings (forward P/E) look stretched. The current forward P/E is 22.7x compared to a 25-year average of 16.6x. However, there are at least two caveats.
1. Historically low interest rates are a critical factor when we look at stock prices and valuations. From another value investing disciple, Warren Buffett, “The most important item over time in valuation is obviously interest rates. If interest rates are destined to be at very low levels… It makes any stream of earnings from investments worth more money.” The spread between the S&P 500 earnings yield and Moody’s Baa corporate bond yield is +1.23% compared to a 25-year average of +0.06%.
2. Analysts’ earnings expectations have consistently been too pessimistic throughout the coronavirus recession recovery period. In last week’s Insight, David covered the potential for profit margin improvement and upside surprises. So far, there have only been 66 companies in the S&P 500 report earnings for the 4th quarter, but 87.9% reported earnings above analysts’ expectations (in a typical quarter since 1994 only 65% of companies beat estimates). There will be 120 more companies reporting next week to give us a good flavor for last quarter’s results and potential beats of conservative estimates.
The latest wave of the coronavirus may have limited some upside to economic activity for the past two months; however, signs point to the end of the corporate earnings recession. Resuming earnings growth and, hopefully, exceeding expectations should relieve some valuation pressure and ground investor sentiment optimism in realism.
Have a great Sunday!
Timothy W. Ellis, Jr., CPA/PFS, CFP®
Senior Investment Strategist, Wealth Strategist