Do Unprecedented Times Make It Different This Time?

Stocks represent fractional ownership in their underlying companies. For this reason I believe the long-term upward trend in the stock market is fundamentally due to the the long-term upward trend in corporate profits. This logic doesn't always explain short-term market moves. Economic cycles and investor sentiment can cause divergence from the long-term average return trends. Right now annual profits for S&P 500 companies are back to Q1 2017 levels, but the S&P 500 index trades 50% higher. Why are investors paying 50% more for the same level of corporate profits? I believe the answer is sentiment. Investors have become wildly enthusiastic that big technology stocks will save the day.

Keep in mind the market is often viewed as a discounter of all future expectations. For this reason it is not unusual to see stocks start an upward trend in the middle of a recession. Typically after an economic disturbance (in this case COVID-19) the initial fear eventually subsides. As investor sentiment improves, a few courageous souls start buying in anticipation of a brighter economic future, which starts a gradual market uptrend. The recent accelerated market run-up has blown this typical gradual pattern out of the water. We've gone from a market bottom to trading at new highs in a matter of months, all during the middle of a recession. As the saying goes, we are living in unprecedented times.

This extreme swing in a short time has me concerned that investor sentiment has become highly speculative. It appears the market has taken on a life of its own. Investors are no longer concerned with boring economic data or old fashioned concepts like corporate profits. They are buying stocks for one reason - they are going up. Rising prices in turn act to increase the markets gravitational pull drawing in even more investors and creating an upward spiraling feedback loop. This can go on for a while, but eventually economic realities tend to catch up with stock prices and a correction ensues. Unsustainable high short term returns are often followed by either a rapid or prolonged market downturn. The result often brings us back around to the long-term average (mean) return trend. Statisticians refer to this as reversion to the mean. Investors just call it mean. Long-term investors call it a buying opportunity in the making.

Remember the dotcom bubble in 2000? The technology heavy Nasdaq ran up over 400%, only to give it all back plus more. More recently we saw the cannabis craze. Starting in 2016 the Alternative Harvest ETF, which focused on this sector, doubled in value in less than two years, but now trades 30% below those 2016 levels. Today's stars are technology companies viewed as immune to the pandemic. Giants Microsoft, Apple, Amazon, and Facebook saw their second quarter sales rise just 7% on a (weighted) average compared to a year ago. Their stock prices have rocketed up over 100% on (weighted) average over the last year. Their stock performance and business performance have clearly disconnected. But it's different this time, right? Probably not. Interestingly, many stocks that don't share the spotlight remain more rationally priced. For example,the average small cap value stock is down over 24% in the last year. Investors with cash waiting for bargains may yet prove to have the right formula.

Frank Rizzo, Certified Financial Planner, CRC

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. The economic and market forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and my not be invested into directly.