May 11, 2020
The S&P 500’s ~30% recovery from the 3/23 trough comes as a surprise to many investors who remain cautious and frustrated by the rally. They remain bearish because equity prices have disconnected from economic fundamentals. Of course, equities are always disconnected from present economic fundamentals as current prices discount forward by 6-9 months. Will economic fundamentals 6-9 months forward be better than today? I think everyone can agree the answer is ‘yes,’ especially when we stop and look at liquidity. This recession was caused by a completely exogenous event. There is no one to blame and therefore, no ‘moral hazard’ to an aggressive policy response. As a result, fiscal and monetary policy to date has been far less contentious than other recessionary periods and far more proactive. The Fed has said there’s no dollar limit and no danger of running out of ammunition. And getting the stimulus to the economy has been far faster than any other time in history because the US banking sector (transmission mechanism) was very healthy coming into the event.
Asymmetry: The stimulus discussed above basically puts a floor under equities and an asymmetric risk profile. Outside of banks, the Fed has also injected ~$2.5T into money supply and if we use the 2008 model as a guide, this is only the beginning. Mechanically this means non-bank investors will be even more overweight cash than they are today and precautionary cash isn’t needed when uncertainty recedes. All that cash has to go somewhere and there are basically three options: 1) cash that yields zero; 2) bonds that yield 1% and going lower as credit spreads narrow further and; 3) equities that should easily command a nominal risk premium in the 5-7% range. I say ‘easily’ because the discount rate in the DCF pricing model suggests something closer to 9%.