On Balance: The noise of summer
By Kyle Tetting
Summer is finally here. The grill has been getting regular use since April. The garden is producing. The return of the Wisconsin humidity and mosquitos were right on time.
There’s something about baseball, though, that says it’s really summer. Of course, the addition of hockey and basketball may be sending mixed signals, but the ability to listen to the Brewers and enjoy a beverage on the patio is a welcome respite from the early months of this pandemic.
Stocks, too, have gotten in on the summer vibe. Stock market trading volume—a measure of how many shares change hands—had been elevated since late February. Trading volumes peaked in March at almost twice the level of a typical March. Though still relatively elevated, volume shrank drastically by July, typically one of the lowest volume months.
Other measures of market calm, such as the magnitude of daily market movements, also eased in July. The number of daily movements of 1% or more in the S&P 500 peaked in March, when 21 of 22 trading days exceeded the 1% threshold. In July, the rate was closer to 1-in-4 trading days.
Increasingly good news on the virus prompted some of the early calm. Success in phase II vaccine trials offered investors long-term hope. Developments on budesonide and remdesivir to treat COVID-19 symptoms also have soothed investors a bit.
Still, the fallout from record job losses has demanded desperate policy responses. The trillions of dollars already appropriated and potentially trillions more will far outweigh the response to the 2008 financial crisis.
Investors have had the luxury of a longer-term outlook because policies have tried to keep people in their homes and stimulated at least modest consumer spending, which has supported stronger-than-expected returns. Early responses also helped calm volatility since February and March.
A logical question is what the long-term costs will be to investors—though you rarely question the medical bill while you’re still in intensive care. Nevertheless, the cost for investors is beginning to emerge.
For starters, record low interest rates project a dimmer picture of bond returns in the future. For the highest quality bonds, interest rates have strong predictive power in the ultimate return of those bonds. A 10-year Treasury note issued today with a coupon of 0.60% is going to earn exactly that if held to maturity.
For stocks, the price-to-earnings ratio holds considerable predictive power. As stimulus boosted investor confidence in stock prices—even as earnings have yet to recover, the forward price-to-earnings ratio quickly moved from reasonable to expensive. To move back toward reasonable, we need either a significant increase in the rate of earnings growth or a slowing of the rise of stock prices to allow earnings time to catch up.
A future of lower returns is not encouraging, but it is important to remember that the impact will not be evenly distributed. Opportunities will exist in new stocks, new regions or entirely new ideas. Further, amid current uncertainty, there’s plenty of noise in forecasts.
Our forecasts for earnings on the S&P 500, an important input in the price-to-earnings multiple, are based on the 500 companies currently in the index. Undoubtedly, as the index replaces less successful stocks with more successful stocks, the outlook improves. Such replacements occur regularly to keep the components of the index relevant.
More importantly, our portfolios aren’t tied to any one index. We build a portfolio more tailored to investors’ specific needs, eschewing the names in the index that don’t fit that narrative. It might mean better returns than what we expect from the index alone. It also might mean a smoother ride.
Finally, a “fair” price-to-earnings ratio for stocks is based on historical observations, not some universal truth about what stocks are supposed to be worth. Accounting for a few extra quarters of earnings growth might support a higher multiple, as does the realization that, relative to other investment options like bonds, stocks may be attractive even at higher multiples.
On the bond side, it’s important to remember the role of fixed income in a portfolio. We look to stocks as a source of return; bonds are simply the ballast. Individual needs and tolerances dictate how much ballast is necessary and in what form, but lower expectations for return do not change the usefulness of bonds in a blended portfolio.
Ultimately, better-than-expected returns in the current environment, supported by policy response and optimism for the future, have weighed on expectations for stock and bond returns. Then again, things never work out exactly as we expect. We will be surprised by good and bad developments with the virus, and invariably some other crisis will enter the conversation.
New developments could mean an abrupt end to our calmer summer or a continuation of the status quo, but the key is that the future will be different than what we expect. An active and diverse investment approach recognizes that unpredictability. It strives to equip each investor with the tools to navigate uncertainty in the short run and to succeed in a long-haul environment where the only constant is change.
Kyle Tetting is director of research and an investment advisor at Landaas & Company.
(initially posted July 31, 2020)
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