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Stone's Weekly Market Guide - Week of April 27, 2020

Chart of the Week: With the S&P 500 now -16% off the February high which translates to a gain of almost 27% off the March low in a little over thirty days, it can be instructive to consider what is priced into the market when the economy and earnings continue to face declines of unknown length and depth due to the impacts of the COVID-19 outbreak. The price-to-earnings (P/E) ratio has risen to over 20 with earnings melting in 1Q and stocks rising sharply off the lows. To smooth out cyclical earnings, using 10-year average earnings in calculating P/E can be helpful (see chart). While P/E using 10-year average earnings is well off the highs, it clearly does not look cheap on an absolute basis but the level of interest rates do matter when valuing anything that produces a stream of cash flows. When considering the level of both U.S. Treasury and corporate yields, valuation levels using 10-year average earnings rank among the most attractive since the 1950s. Valuation is a poor market timing guide and stocks have certainly been cheaper at times, so investors should be prepared for further volatility as the market grapples with the timing and strength of the eventual earnings recovery. With the nominal safety of the 3-month and 10-year Treasury yields at 0.1% and 0.6%, odds do continue to favor retaining a long-term allocation to stocks while being mindful of the short-term downside risks.


Price-to-Earnings Multiple and Normalized Price-to-Earnings Multiple

Week in Preview


· Geopolitical: Economic activity is extremely weak with much of the world on lockdown to fight the spread of the coronavirus, but now attention has begun to turn to easing restrictions and restarting economies. Many markets across Europe and Asia are closed on Friday for the May Day holiday. OPEC+ supply cuts are expected to take effect on Friday.


· U.S.: Filings for unemployment benefits reached 6.9 million on March 27 and will likely see a less gruesome but still bad level of around 3.5 million this week. The 1Q GDP report will give us the first glimpse of the upcoming economic damage from the outbreak with consensus looking for a -3.9% quarter-over-quarter (Q/Q) annualized rate even though lockdowns began in mid-March, but the range in estimates is wide with declines as large as -10%. To put it into perspective, 4Q 2008 GDP during the global financial crisis (GFC) declined by -8.4%. The phase 3.5 fiscal stimulus package, which provides an additional $310 billion in funding for the small business Paycheck Protection Program (PPP) along with additional money for disaster loans and grants, health care providers and coronavirus testing was signed into law with the PPP expected to reopen Monday. Discussions around a CARES 2 stimulus plan to support the economy have already begun. The Federal Reserve (Fed) meeting should bring no major changes in policy following the recent emergency actions with Chair Powell continuing to pledge to do whatever it takes to support the economy.


· S&P 500 1Q Earnings Season: With 24% of companies reporting so far, 60% of companies have exceeded earnings estimates. The 1Q blended earning growth rate fell to -15.8% year-over-year (Y/Y) which deteriorated from the previous week primarily due to the financial sector. With 1Q earnings generally heavily trimmed by COVID-19, more attention is paid to forward guidance with 2020 earnings now expected at -15.2% Y/Y. Even judging future estimates is complicated with many companies removing earnings guidance due to the unknown depth and length of the shutdown related economic weakness. 172 S&P 500 companies expected to report including GOOGL, SBUX, MSFT, AMZN, MCD and XOM.

· Europe: The Eurozone reports 1Q GDP which is expected to decline by -3.5% Q/Q annualized but estimates are as low as a -6.2% decline. In contrast, Eurozone GDP shrank by -3.2% in 1Q 2009 during the GFC. The European Central Bank (ECB) is expected to make no major policy changes but President Lagarde could discuss future possible actions.


· Asia: The National People’s Congress of China meets in Beijing through April 29. March China PMI data will be watched for a sign of the future possible path for the U.S. and rest of the globe. The Bank of Japan (BoJ) increased the size of asset purchases by pledging unlimited government and doubling corporate bond purchases.


Central Banks: In addition to the Fed, BoJ and ECB, the central banks of Kazakhstan, Sweden, Hungary, Georgia, Kenya, Botswana, Bulgaria, Guatemala and Colombia meet with Kazakhstan and Colombia expected to cut their policy rates.


Week in Review


· Stocks fell by -1.3% for the S&P 500 with only one of eleven sectors higher. Energy (1.7%), communication services (-0.04%) and consumer discretionary (-0.2%) outperformed the S&P 500, while real estate (-4.4%), utilities (-3.8%) and consumer staples (-3.2%) were the biggest laggards. WTI (-7.3%) and Brent (-23.6%) were lower, but MLPs (9.9%) and the energy sector (1.7%) were significant outperformers. Oil was a major topic with the WTI May futures contract closing at a historic -$37.63 on Monday, in other words traders has to pay rather than be paid for someone else to take delivery of physical oil due to the lack of demand and high storage costs. Small cap stocks outperformed the S&P 500 with the Russell 2000 up 0.3%. The 10- and 30-year U.S. Treasury yield dropped to 0.601% and 1.17% respectively.


· High yield credit spreads widened and AAA municipal bond yields as a percent of Treasuries increased, reflecting decreased risk appetite. Municipal bonds underperformed as discussion about allowing states to declare bankruptcy reemerged, but this should remain an unlikely outcome with the heart of this issue really the size and distribution of Federal government aid to the states.


· The U.S. dollar was stronger against both developed and emerging market currencies. Developed international stocks as measured by MSCI EAFE underperformed the S&P 500 returns in U.S. dollar terms (-2.1%) and on a hedged-currency basis (-1.5%). Emerging market stocks underperformed the S&P 500 with the non-hedged return of -2.4% for MSCI EM.


· The 10-2 yield curve narrowed to +37.2 basis points. Another curve measure of three-month yield six quarters forward minus the current three-month yield also steepened and closed the week at +17 basis points. The yield curve has historically provided an accurate forecast of future recessions when the difference in these measures turns negative, also known as inversion. Yield curves are one of the major indicators that we monitor to judge recession risk, but these inversions typically happen more than a year in advance of an economic recession and external shocks like the current outbreak might not be accompanied by one. Stocks have historically had significant advances post-inversion..


The PDF version of Stone's Weekly Market Guide is linked here.

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