It’s Always Darkest Before the Dawn

John P. Swift, CFA, CPA Chief Investment Officer
312-259-9595 or jswift@trustbenchmark.com
November 15, 2020

The English theologian and historian Thomas Fuller is the first person to commit the notion that ‘the darkest hour is just before the dawn’ to print. His religious travelogue A Pisgah-Sight of Palestine And the Confines Thereof, 1650, contains this view: “It is always darkest just before the Day dawneth.”

This metaphor seems appropriate as we enter a winter of COVID discontent and the threat of containment efforts that may create adverse economic outcomes. But the market appears to be discounting the current uptick in COVID cases as the last gasp of an illness that has met its match in the form of superior science and human ingenuity. It may look dark now, but the market clearly sees a brighter future and the coming of the dawn marking the beginning of the end of this insidious virus.

COVID-19 Vaccine

The reason for this hopeful outlook is due to the news this past week that the vaccine joint venture between Pfizer and BioNTech showed an extraordinary 90% effectiveness during Phase 3 trials. To give that number some perspective consider that your normal flu shot is normally around 50% effective. The measles vaccine is 93% effective, and Measles was declared eliminated (absence of continuous disease transmission for greater than 12 months) from the United States in 2000.

Very few researchers at the CDC and NIH predicted that the vaccine would be that good, and the market responded accordingly with the Dow Jones Industrial Average jumping 834 points last Monday boosting stocks of companies seen benefiting from the economy’s reopening, while hitting shares of the stay-at-home winners, including the mega-cap technology leaders.

Of course, the vaccine will not be able to help us through this cold & flu season that is upon us, and soaring COVID-19 cases could spur shutdowns that might be less drastic than those earlier this year, but would still hit the economy. We are already seeing a marked slow down in credit card activity especially in states in the upper Midwest most adversely affected by this wave of outbreaks.

Even Federal Reserve Chairman Powell commented on Thursday that while he sees the economy in a solid recovery, with the virus now spreading, the next few months will prove challenging.

It is always darkest before the dawn.

New Vaccine Comes from New Technology

The Pfizer/BioNTech vaccine is the first clinical proof of messenger RNA technology (mRNA) they employed. And that bodes well for other companies exploiting mRNA techniques, such as Moderna (MRNA), CureVac (CVAC), and Areturaus Therapeutics Holdings. The other benefit of this technology is that it enabled Pfizer/BioNTech to get a viable vaccine together in months, as opposed to the usual years.

Politics & Fiscal Stimulus

Turning to the political scene, the market believes the Georgia senatorial run offs on January 5th will result in a Republican controlled Senate. With Joe Biden being installed as the 46th POTUS we will get a combination of less uncertainty about foreign trade wars and no new taxes as the assumed Republican control of the Senate will thwart any attempt to change dramatically industrial and tax policy.

Additionally, the market has come to believe that, albeit significantly slimmed down from the house approved version of fiscal stimulus, we will be provided with a stimulus package in the $500 billion range. That is nowhere near the $2.2 trillion that House Democrats proposed, but something is better than nothing if it comes early in the new legislative session next January.

Earnings Outlook

Corporate earnings growth for 2021 has a consensus estimate of 22% growth presently, according to FactSet. That robust rebound in corporate profits comes courtesy of the assumption of an effective COVID vaccine and the rather euphoric rebound in consumer spending due to pent-up demand that the prospects of life returning to normal will unleash.

Additionally, companies were forced to slim down and cut costs to survive in 2020, and that leaves these companies with terrific profit leverage in the face of improving demand next year.

Value vs Growth Stocks: Is it Finally Time for Value Stocks to Shine?

Value stocks, which trade cheaply based on metrics such as price-to-earnings and price-to-book value ratios, usually have beaten growth stocks coming out of recessions. And value has rarely been so cheap compared with growth based on these valuation measures since value first went out of favor after the housing crisis of 2008-2009.

We believe that the economy will run better than expected in 2021 because of the lagged effect of monetary and fiscal stimulus from this year, as well as the corporate cost-cutting that followed the onset of the pandemic in the spring.

As you know, we have been heavily skewed towards growth stocks since 2009, but we have added significantly to cyclical/value stocks during 2020 in advance of what we see as an improving economy. But we are not throwing out the growth stocks as any rebound will be a choppy, non-linear event. But with the economy resuming normal business activity next year and much easier earnings comparisons among cyclical/value stocks we will continue to add to the “economic reopening” positions as they may hold the best potential for market-beating returns.

Market Valuation

Many investors have become nervous about what they perceive as the high valuation of the current market as compared to historical averages. Today’s 21.8x price/earnings ratio on forward earnings projections looks expensive. But consider when the market peaked in March 2000, it was trading at 26x forward earnings, and the 10-year Treasury bond was yielding 6.2%. Today, the 10-year Treasury is trading hands at just 0.90%, and lower interest rates mean that lower discount rates make future cash flows more valuable today. This, in turn, indicates that justified price/earnings multiples should be higher as compared to historical averages which include average discount rates much higher than at present.

We believe that after we experience the continued improvement in the economy, we will look back at the present valuations and all agree that was a good time to buy into or add to equity positions.

As I stated earlier, corporate profits are forecasted to grow at a 22% clip next year, and if valuations stay exactly the same, we should still enjoy the continuation of the market rebound since its nadir last March in the form of this robust profit growth.

The Possibility of a Post-WWII Type of Consumer Spending Explosion

At the end of World War II, American soldiers returned home to a country quite different from the one they had left four years earlier. Wartime production had helped pull America’s economy out of depression, and from the late 1940s on, young adults saw a remarkable rise in their spending power. Jobs were plentiful, wages were higher, and because of the lack of consumer goods during the war, Americans were eager to spend. During the same years, young couples were marrying and having children at unprecedented rates. New and expanded federal programs, including the G.I. Bill of Rights, allowed many young families to purchase their own homes, often located in rapidly expanding suburbs.

Today, we are all COVID soldiers hunkered down inside our foxholes, and when COVID ends we will emerge back into a quite different world. We will all be eager, if not euphoric, to step back into our pre-COVID lives and the freedom we took for granted. Jobs and employment will be higher, and we will be eager to spend. We will dine in restaurants, fly on planes, visit Mickey Mouse, get pregnant, watch movies in crowded theatres, and, my favorite, enjoy live music and restaurants without the embarrassment of attempting to eat my food through my mask.

Sound good?

This new day is coming, and we only need to remember that it is always darkest before the dawn, and the light of dawn will shine brightly upon all of us soon.

Catching Up

We look forward to catching up with each of you, and we will be reaching out to schedule a time to meet over the phone or by a Zoom/MS Teams video link. In the interim, if you would like to get something on the calendar, please send me a note with some dates and times.

Warm regards,

John