I hope your summer is going well. Here in the New York metro area, the new strain of COVID has once again filled emergency rooms and while the vaccines help mitigate the symptoms, they aren’t stopping the disease entirely.
That’s a real shadow as we approach the traditional back-to-school season. If we want American parents to get back to work, the schools need to reopen. And if we want the schools to reopen safely, the virus needs to be under control.
Meanwhile, the economy itself remains brittle enough to keep the Fed pumping billions of dollars a month into the market, even if it means embracing inflation. Millions of people have gone back to work but millions are still unemployed as well.
Add the prospect of higher taxes to pay off trillions of dollars in government stimulus and a potential debt ceiling fight ahead, and it’s no wonder a lot of investors (large and small) are anxious.
After all, investing is all about putting money to work today in order to build wealth over time. You want the future to be better than the present. When you lose faith in that basic proposition, you look for safe places to protect what you have.
And after a full year of higher-than-normal volatility, the fastest recession in history and the worst public health crisis in recent memory, a little extra caution is natural. We’re all a year older. We’re tired, even a little cynical.
It’s hard to trust the future after a year of shocks. When we see the S&P 500 up 31% in the past 18 months, it feels unreal . . . even unearned. Unsustainable. One of the first things we learn on Wall Street is that if something looks too good to be true, it probably isn’t. What goes up for no reason ultimately comes down again, often violently.
But throughout history, American ingenuity and spirit have overcome every obstacle. Over a long enough time frame, stocks have always gone up and shareholders have always reaped the rewards.
I don’t see anything in the world today to shake my conviction in that basic fact. Unless some fundamental fact about our economy and our nation has broken in the past year, the future truly will be better than the present.
Stocks will go up. Maybe you’ve lost faith in that basic proposition. Let me walk you through a little of my logic. First, however, let me express my thanks for being here as we embrace a new and more independent future together as investors.
I know the road hasn’t been perfectly smooth. Life gets bumpy. But as long as we focus on the destination, we can grit through the less-than-perfect parts and get through it.
At least on Wall Street, the perfect can truly be the enemy of the good. I am fanatical about details. But I accept that if we waited for perfection, we would never invest at all because the truly “perfect” set up never comes.
We’d stay on the sidelines forever. That’s not life. That’s dead money.
The Pandemic Was Not A Zero-Sum Circle
During the worst moments of the pandemic, a defensive rebuilding mentality took over. We knew it was bad. The best that a lot of people could hope for was that sooner or later the corporations we invest in would be able to stop bleeding cash and repair their profit margins before they ran out of money.
Initially, that came down to a battle for survival. Actual year-over-year earnings growth seemed unattainable when so many industries were so deep in the hole. Before these companies could even think about boosting profits and justifying higher stock prices, they needed to recover all the ground they’d lost.
Earnings in the S&P 500 sank 15% last year from 2019 levels. It could have been much worse, but between PPP loans and the Fed, stressed employers managed to avoid the kind of total cascading defaults we saw in 2008.
Survival became less of an open question. Alert executives started pivoting their operations to exploit opportunities, building out home delivery and virtual collaboration capacities or simply conserving their cash.
Investors recognized that stocks priced for the apocalypse were not actually going to collapse as long as the Fed was in the picture. You don’t fight the Fed. The Fed wanted to cushion the economy and was going to do everything possible to keep these companies alive.
But in the process, trillions of newly printed dollars flooded into the stock market and asset valuations got stretched. Suddenly, the real economy plunged into a deep recession while the S&P 500 swelled into the bubble zone.
A bubble will burst unless the fundamentals can follow the expansion fast enough to alleviate the pressure. In that scenario, a temporary “bubble” feeds into a bona fide boom.
Remarkably, that’s just what the headline numbers tell me happened between 2019 and 2021. Someone who went to sleep two years ago and only woke up today would look at the Wall Street Journal and think nothing catastrophic had happened in the economy in the intervening time.
Two years ago, the S&P 500 earned $163 per share and we were cautiously optimistic that we’d see reasonable 8% growth in 2020. The lockdowns destroyed those expectations, leaving us staring at that 15% decline I mentioned earlier.
A 15% earnings decline across the entire market is not a bull scenario at any price. We had to stomach only $140 per share across the S&P 500 last year. It stung. If not for the Fed, stocks wouldn’t have been able to justify their current valuations . . . and a rally would have been unthinkable.
But here we are now. Dollar for dollar, the economy is now $200 billion larger than it was before the pandemic. The COVID recession is theoretically over. And while the Fed’s blunt instrument wasn’t able to cushion every company equally well, I’m fairly confident we’ll get $203 per share on the S&P 500 by the time 2021 is over.
That’s 24% above where we were at the pre-pandemic peak. Across a two-year period, it’s about 11% compound annualized growth . . . about as good as what we saw in 2017 and worth a significant premium as long as it lasts.
I admit, growth will slow from here. But we might still see 9% expansion on S&P 500 earnings in 2022, which is better than what we thought we’d get in 2020 before COVID took it all away.
From Bubble To Boom
Once we start looking into 2022 and the lockdowns recede in investors’ memories, the long bull trajectory from the first weeks of 2020 looks earned.
If earnings end next year up 35% over the three-year period, it’s logical to argue that stocks deserve to climb about 35% in that time without getting too far ahead of the multiples we all accepted 18 months ago.
Of course, some will say the market was already overextended going into the pandemic. But even if Wall Street loses its appetite for slightly rich valuations, consider: unless growth hits a hard wall late next year, a reversion to “average” multiples (stretching back a decade) pushes the S&P 500 down to 3,900 before the “P” side of the “P/E” calculation can recover.
That’s not a crash. That’s a simple, regular, healthy 10-12% correction. They usually last a few months while investors rotate their positions and corporate executives take a quarter or two to shuffle their strategies.
In that scenario, we’re already looking out to mid-2023. At that point, the Fed will take a hard look at the economy before changing its rate posture. If companies are making a lot of money, we’ll be able to tolerate a little tightening . . . it might even feel good after a year or two of inflation, and the banks will cheer.
The Future Is A Moving Target
And by Wall Street standards, that’s a long way in the future. It’s farther ahead of today than the start of the pandemic is behind us now. A lot can happen in 24 months.
We’ve seen how fast companies can move under pressure. That accelerated rate of innovation is not slowing down as they see that they need to stay ahead of inflation, taxes and the unknown.
That can be bewildering to investors but accelerated change can be a good thing if you can stay focused on the long trends. They point up.
Never forget that “the market” tends to rise 8-11% in a typical year across the economic cycle, boom and bust. That’s been true since before the Great Depression. It remained true in the 2008 crash.
Of course there will be good and bad years, upsets scattered within the upside. But on average, unless something fundamental breaks in the American spirit, we can expect 8-11% compounded over time.
On that basis, 31% in 18 months feels a little accelerated, yes. Future gains may be more grudging, following more of the “gentle float” pattern we saw in 2014-18 while earnings catch up.
That might not feel bad after a year of shocks. And of course we don’t have to settle for that. We can pick the strong stocks and avoid the weak ones that the S&P 500 is forced to include in its index.
My GameChangers, for example, has only needed about 180 days historically to book that 11% return, position by position across over a decade. You can see how that outperformance compounds in the long haul.
If you’re new around here, I recommend you take a look. Ask questions about the track record. I can be reached through email@example.com.
And whether you’re an old friend or a new investor, if you’re worried about the future, feel free to reach out. Maybe I can’t convince you that the future points up and maybe you don’t want to be convinced. That’s all right.
But from here, despite all the speed bumps and swerves, the future looks brighter than it has in years. It isn’t perfect yet. It’s becoming more perfect every day.