Stock market excitement intensified in August, but is it reasonable? | Luminor

August was another positive month for equity markets as investor euphoria towards largest and most popular equities in USA only intensified, while US Central bank announced major policy shift towards higher inflation, and thus potentially towards creating even more liquidity, if that would be needed. In addition, contrary to Europe, number of new COVID-19 cases in USA started to decline. As a result, all these factors helped to propel S&P-500 index to new all-time highs and widen discrepancy in performance between USA and the rest of the world.

Last time we already mentioned that investor sentiment towards FANMAG1 stocks and Tesla is reaching rather extreme levels and hardly can be justified by future growth levels or other fundamentals. In august we received even more evidence of such euphoria. When $250 billion company rises by more than 80% in three weeks on no particular news and largest company in the world goes almost 40% higher since late July to reach market capitalization of 2.2 trillion2, there is no need to be investment professional to understand that such moves are almost certainly driven not by rational investment process, but predominantly by speculation and mania. 

Performance of selected stocks


Source: Bloomberg

In general, manias happen very rarely and probably one of the most recent and well-known occasions of similar behavior could be linked to bitcoin price surge during late 2017. It is true that during mania stage it may be relatively easy for participants to enrich themselves, as price dynamics is going only in one direction and change happens incredibly fast. But, from longer term investment perspective, it quite often does not pay off to participate in such ideas, as price changes are not driven by rational market factors, but by short term excitement and greed on the assumption that there would still be more buyers than sellers in the future. Therefore, investors who decide to participate in manias, in essence, become transformed to speculators and start playing “guessing game”, which for majority of participants in the end also becomes a losing game, as reversals tend to happen even faster than price increases, making what for the long time appeared to be profitable position immediately unprofitable3.

Capitalization of selected equities vs combination of selected indices


Source: Bloomberg

Capitalization of Apple vs US small cap index


Source: Bloomberg

To be fair, mania in certain stocks was not the only factor that contributed to positive performance of indexes. Steady decline in new COVID-19 cases in USA allowed confirming that second wave has likely ended there even without strict shutdown measures this time. It is encouraging and allows cautiously to suggest that worst might be over if not from perspective of future public health developments, then at least from perspective of business closures and lockdowns. Also in late august FED chairman Jerome Powell announced that FED will no longer target to have 2% inflation and in order to create jobs and GDP growth may pursue higher inflation targets. Though, such message does not have immediate impact on monetary policy, it still seems to send encouraging signal for investors, that FED is willing to increase money supply even further, if situation would require such action. 

New daily cases of COVID-19 (7-day average)


Source: Bloomberg

However, right now it is important also to differentiate between investor located in USA and investing only in local market against investor located in Europe and investing in global context (our case). Records in USA come with the price. By substantially increasing monetary supply, which contributed to equity prices going higher, FED at the same time triggered substantial decline in US Dollar. Since middle May US dollar declined to Euro by more than 10%. Additionally, spread between equity returns in USA and rest of the world since the beginning of the year widened to around 14%. In EUR terms, performance of global equities excluding USA since the beginning of the year is still around -10%, which in our view, more adequately resembles global economic situation that is observed in 2020, when not influenced by euphoria and investor mania. 

YTD price return  of selected MSCI indices


Source: Bloomberg

Global economic situation indeed remains challenging. While majority of macroeconomic indicators show improvements when measured on a month over month basis, almost all of them still remain below their respective levels observed last year. It still remains not clear how new increase of COVID-19 cases in Europe would impact economic activity inside this region in autumn.  It is also not clear what would be macroeconomic data in USA after democrats and republicans failed to agree on new stimulus bill in August. Indirectly, we already see some signs of potentially weaker consumption going forward, as judged by consumer confidence data. And as you can see from the chart, such data almost always means trouble ahead for equity markets. 2020 in that regard is truly exception.
  
S&P-500 performance vs consumer confidence


Source: Bloomberg

Considering the extremely low interest rate environment, stocks still manage to provide a decent risk premium over bonds, as earnings are expected to gradually rebound, while many bonds are yielding close to 0. However, stock market valuations are at highest level since late 90s while economy is undergoing one of the most severe economic recessions in recent history, so chasing the market currently may turn out quite risky. Remember, when equity indices toped in 2000, US indices were not able to surpass that highs for 13 years after that, while majority of European indices have not surpassed 2000 ever since.  That is why despite what might be one of the strongest equity rallies in USA, it makes sense to stay calm and not follow speculative impulses to aggressively pursue such rally but to pursue long term investment goals instead. 

S&P-500 performance and valuation


Source: Bloomberg


1Acronym for Facebook, Apple, Netflix, Microsoft, Amazon, Alphabet (Google)
2These companies are Tesla and Apple
3Market sell-off in early September provides partial evidence of this risk

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