The stock market advance since the March 23 low has been relentless and spectacular. It's gone farther than seemed possible especially given the economic toll of the coronavirus and looming government shutdown. Given that unemployment is expected to top 20% and many businesses won't survive, the stock market's optimism is surprising.
Bull Market or Bear Market
Even more impressive, a handful of stocks are making new highs. This type of behavior is more consistent with corrections within bull markets rather than bear markets. One possibility to explain the divergence between stocks and the economy is that stocks are responding to the situation improving on a marginal basis in terms of the virus' spread being under control. Additionally, the economic weakness is leading to record-levels of fiscal and monetary stimulus.
The case for Lower Multiples
Even with these developments, it's hard to imagine a world where corporations are going to earn the same amount of money until some sort of vaccine is developed. It seems more likely that consumers and businesses will be saving more money, companies will face restrictions on spending money on buybacks, and there will be more focus on resilience rather than profitability. All of these factors will be negative for multiples.
This is the bear market argument. Multiples are going to be lower, and corporate earnings will be lower given the shutdown and lower rates of economic activity going forward. Before the coronavirus outbreak, earnings for the S&P 500 (NYSE: SPY) in 2020 were expected to be between $150 to $170 which gives it a multiple between 20 and 22.5 at the peak in February. Currently, earnings are estimated to be around $120 for 2020 which gives a multiple of 23.7. Stocks are now more expensive than before the crisis.
Historically, bear markets have bottomed with multiples between 6 and 15. So far, stocks are willing to shrug off the damage and are trading as if the world is going to return to normal in the coming years.
Has the Stock Market Bottomed?
The stock market is a forward-looking entity, so it can diverge from the economy for temporary periods. However, at a certain point, the economic data has to justify the market's optimism or pessimism. In late March, bearish sentiment reigned, and it seemed foolish to be optimistic about anything. Now, the stock market's price action is making bears look silly.
Banks like Goldman Sachs (NYSE: GS), Morgan Stanley (NYSE: MS), and JPMorgan (NYSE: JPM) are looking for a V-shaped rebound in stocks back to new highs by the end of the year or first quarter in 2021. Investor sentiment hit extreme levels of bearishness in late March, so conditions were ripe for a powerful, countertrend move as the government stepped up with stimulus and the virus' growth has gone from exponential to linear.
Now, the stock market seems to be complacent about risks. Stocks are overbought on a short-term basis. Participation in this move higher has thinned out, meaning that fewer stocks are lifting the market higher, making it more vulnerable to selling. Additionally, the sharp selling in the stock market led to a temporary moment of unity in which Democrats and Republicans worked together to pass legislation. This moment seems to have passed, and normal partisan bickering has resumed. Additionally, Congress is on recess until early May.
While many are anticipating a "reopening" of the economy in early-May, there doesn't seem to be any serious steps to come up with testing and tracing programs that have been implemented in other countries. And even those countries have faced secondary outbreaks. Reopening the economy also doesn't mean that the economy will be back at full capacity like it was before the outbreak.
These conditions are creating an opportunity to build positions on the short side for short-term traders with a stop-loss at 3,000 on the S&P 500. Longer-term investors should remain patient and wait for another period of fear before putting money to work. This is the time to bet against a V-shaped rebound in stocks.