the pandemic

In 2Q20, S&P 500 earnings fell by about a third, year on year. Stocks rose nonetheless, mostly because of immense monetary stimulus put in place by the Federal Reserve that drove interest rates effectively to zero. The complete lack of investment allure of zero-yielding fixed income made any stock attractive in comparison.

A second pandemic effect on the market came from the panicked, hide-under-the-bed reaction of the Trump administration to the crisis. This had two stock market effects: interest rates were lower than might have been the case had Trump acted to stem the pandemic; and investors swung their portfolios sharply away from purely domestic names (look at the behavior of the Russell 2000) toward multinationals, in addition to the typical move in a weak economy away from cyclicals toward secular growth stocks. (I think the parallels between Trumpism and 1930s Germany also introduced a significant flight capital element into the market, but my sense is that, while lurking in the background, this is not an important current theme.)

One consequence of all this is simple arithmetic. Compared with the pandemic lows of last year, 2Q21 results will likely be very strong. For company earnings just to get back to the 2Q19 profit level, however, eps have to rise by 50% from last year’s level. To get a better handle on where profits are, many analysts have taken the sensible step of comparing 2Q21 results against pre-pandemic 2Q19. This suggests to me that some otherwise eye-popping results will fail to impress Wall Street.

As the economy recovers (absent a new wave of domestic fascism), Wall Street will presumably have much more enthusiasm for domestic cyclical results than for those from secular-growth multinationals.

Thirdly, at some point–and we’ve already seen one false dawn already–the financial markets will begin to factor in a return of monetary policy to normal. We’ll see this in higher interest rates in the money markets and a consequent contraction in price-earnings multiples for stocks. The importance of the rate rise in March is not so much that it showed how little market influencers know about inflation, but that it’s a dress rehearsal for how the market may react when rates actually begin to return to normal.

more tomorrow