Irvin Fisher was a prominent US economist who made many significant contributions to his field in the early 1900’s. Nobel-winning economists Milton Friedman and James Tobin have called Mr. Fisher “the greatest economist the US has ever produced.” His work became the basis for many economic theories still in use today, including the rationale for the current monetary policies of the U.S. Federal Reserve. Unfortunately, however, Mr. Fisher is best known for his 1929 conclusion that the U.S. stock market had "reached what looks like a permanently high plateau." The Great Depression started nine days after he made this statement. He subsequently lost his fortune in the equity markets and spent the rest of his days nearly penniless, living in housing provided by Yale University, his alma mater. His story has become a cautionary tale for anyone making financial market predictions.
Equity market valuations are a common topic of conversation so far this year. The financial press seems to discover a new equity bubble every other day. Certain pockets of the market do seem to be showing signs of “irrational exuberance” with price increases of 5-10 times over the past year, often with little to justify the change other than hopes and dreams of new technology.
It is natural to wonder if today’s equity market is completely divorced from reality. For certain segments of the markets, this may be the case. However, the broad equity market may be priced closer to reality than it appears. Earnings drive markets, as we are fond of reminding. We are in the middle of one of the most surprising periods of earnings outperformance that the S&P 500 has ever experienced. As of January 25th, 2021, actual earnings for the 4thquarter of 2020 were 20% higher than analyst estimates. This level of corporate outperformance has only happened once before…during the 3rdquarter of 2020. Using the five-year average, analysts underestimated quarterly earnings by 6.3%. Underestimating earnings by 20% just does not happen at the broad equity market level, but here we are.
Despite the challenges presented by COVID-19, corporate America has returned to 2019 profit margins. In aggregate, challenges to business operations, such as the added cost of new safety procedures and supply chain bottlenecks, appear to have been neutralized. A dollar in sales again results in roughly 10 cents in profit for S&P 500 firms, just as before COVID-19. Aggregate sales and earnings are below the 2019 peak, but it seems probable this will change by the middle of the year as vaccines are more widely distributed. The efficiencies businesses have developed over the past year will outlast the virus, suggesting further gains to corporate profit margins. It is conceivable that American businesses will leave the COVID-19 era stronger and more efficient than before, a stunning turnaround from the sentiment that prevailed in March 2020.
Catalysts for improved profit margins, beyond new operational efficiencies, are those we have been discussing for months: low interest rates from the Federal Reserve, stimulus from Uncle Sam and rapid vaccine development. The Fed reassured markets this week that low rates will continue for as long as needed. Another stimulus bill should materialize, though some political debate is expected. Vaccine distribution has been slow but estimates of a mid-year “opening” still appear achievable. In the U.S., the current vaccination pace is >1M per day, and new vaccines (J&J) are expected to be announced shortly. As a result, U.S. GDP
growth estimates have now moved above 5% for the year. The last time the US saw that level of economic growth was the late nineties and that figure is roughly double what we experienced over the past decade.
While there are legitimate reasons for optimism, numerous difficulties remain. Financial distress is a very real issue for many families. Twenty percent of renters, approximately 10 million units, are on average $5,600 behind in rental payments. This is more than one month’s salary for the median U.S. household after taxes and withholding. Eviction restrictions have been extended through March, but at this point there is no Federal policy to directly address the $56 billion owed in back rent. The unemployment rate is 6.7% and weekly job losses have been consistently above 900k for nearly two months. It will likely take several years for the unemployment rate to move back under 5%, which is considered average for a healthy economy.
Dr. Fisher’s economic framework was inadequate for the events of the late 1920s and 1930s. Being so wrong caused serious personal reputational and financial harm. A person of lesser character may have disappeared into the night never to be heard from gain. But Dr. Fisher learned, adapted, and came back stronger. Many of his most important insights came from his efforts to understand the causes of the Great Depression.
The global economy was embarrassingly unprepared for the pandemic, but much like Dr. Fisher’s experience, lessons have been learned and changes have been made. It really is astonishing how quickly businesses, consumers and healthcare have adapted and evolved to the realities of COVID-19. It has been a harrowing process.
Our role is to provide a sober assessment of capital markets opportunities and risks, as we see them. In summary, the opportunities are growing corporate profit margins from operational adaptations and easy money conditions, along with stimulus to support consumer spending. The risks are continued high unemployment and financial stress for many families throughout the country. This combination both seems to support current market prices and will likely result in continued market volatility for the short to intermediate term.