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Equity prices diverge further from fundamentals


4 June 2020

The rally in global stocks led by the US has taken some indices close to their record highs made before the Covid-19 outbreak. The Nasdaq composite has gained 46% since bottoming out on March 23 and is only 1.6% away from its all-time high, while the S&P500 is up 42% for the same period and just 8.7% from its record. This has now officially become the strongest ever rally following a major shock.

I admit that I am astonished by how far risk assets have moved over the past 50 days, and one thing we might have learned is to follow the central banks regardless of our views on economic fundamentals.

Although some metrics are showing signs of improvement, the real economy is coming from an exceptionally low base. With more than 40 million Americans applying for unemployment benefits since the beginning of the crisis and an expected contraction of 52.8% in second-quarter GDP according to the Atlanta Fed, the disconnect between asset prices and economic fundamentals is hard to justify. Add to this a 12-month price to earnings ratio of 22 times for the S&P 500 which is the highest since the 2000 dot com bubble and things don’t make a lot of sense.

Coming back to the point of following central banks regardless of your views on fundamentals, the question becomes how much further can central banks continue supporting markets? That depends on so many factors including actions from fiscal policymakers, the economy getting back to life, the discovery of a treatment or vaccination for Covid-19, no second wave of infections and layoffs, consumers’ confidence in spending and companies generating positive cash flow. If these factors remain missing, the rally in stocks may not last much longer.

That is not to say you should bet against stocks. The rally could have another leg higher, especially as the dollar looks to be on a downward trajectory, which may be a sign that investors are growing more optimistic and increasing their risk exposure. However, for those who have made significant gains over the past couple of months, protecting their portfolios from the downside may be a good idea.

#source

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