Unemployment & Market Valuations

John P. Swift, CFA, CPA Chief Investment Officer
312-259-9595 or jswift@trustbenchmark.com
May 11, 2020

A Silver Lining in the Unemployment Report

The April employment report, which was released on Friday, was flooded with bad news, but had, perhaps, a silver lining around the dark cloud hanging over the labor market.

When Bad News is Less Bad Than Feared, it is Good!

The unemployment rate and underemployment rate are going to be instrumental in driving voting decisions this November. The April employment report did not change that assessment.

There was a lot of bad news in the report, which included 20.5 million job losses and a 14.7% unemployment rate. Both were the highest numbers recorded in the post-World War II era. The U-6 unemployment rate, which measures unemployed and underemployed workers, shot up to 22.8% from 8.7% in March. However, both unemployment statistics were well below the median of analyst’s expectations, and in the minds of investors, that is “good” news.

Naturally, the stock market rallied on this “good” news, and at the same time, the market was encouraged to see that 18.063 million, or 78.3% of unemployed workers, were categorized as being “on temporary layoff.”

Being “on temporary layoff” implies an expectation among those who were laid off that they will be employed again soon. That is an encouraging thought, because the U.S. economy does a lot better when more people are working and making money. This categorization also provided some fuel for the recovery trade as it sunk in that the economic recovery could happen more quickly if these workers are asked to return to work soon.

Source: Facset

We don’t disagree with the premise, yet we have some doubt that the masses will be asked to come back as quickly as they were told, and if they are, they may not be asked to come back in the same capacity. That is, some may be asked to return to work soon, but at reduced work hours (which means less income than before).

That should be particularly true for the leisure and hospitality industry. Employment rolls there dropped by 7.7 million, and while states are pursuing reopening plans, limits are being set. For example, a restaurant may be allowed to reopen but only at 25% of its normal capacity. Clearly, under such conditions a restaurant would need far fewer workers than it did before.

Hotels, meanwhile, could see more business as economies reopen, but both the business traveler and leisure traveler will be slow to return amid ongoing health concerns. Hence, a hotel with a 30% occupancy rate is not going to need as many workers as before.

What We are Watching on Unemployment

What is “temporary” in a worker’s mind today could unfortunately become longer lasting. We will get some insight on that condition in the coming months by looking at the percentage of workers who have been unemployed for 27 weeks or more.

That number dropped to just 4.1% of total unemployed in April, but that was a function of so many people having only recently lost their job. Notably, individuals who had been out of work less than five weeks accounted for 61.9% of the unemployed while individuals who had been out of work between five and 14 weeks accounted for 30.4% of the unemployed.

Another metric to keep a close watch on is discouraged workers. They totaled 574,000 in April versus 514,000 in March. Discouraged workers are individuals who are not looking for a job because they do not think there are any jobs available for them. This is not a number you want to see moving up for many reasons.

The Way Forward on Employment

The labor market has been shaken to its core with the shutdown measures aimed at containing the spread of COVID-19. The April employment report left no mistake about that.

Things, though, are destined to get better. The questions are, how much better and how soon?

There are a lot of variables that go into answering those questions, including the pace and degree to which businesses open again, the pace and degree to which people feel confident about the health risk they are accepting in the absence of a vaccine, and the pace and degree to which consumers and businesses alike start spending again.

Those things will be made known in coming months and they are certain to have a transformative effect on the economy because of what they will mean for the labor market, which saw a 100-year flood of job losses in April.

Revisiting the Stock Market Valuation

In last week’s note (“The Way Forward – Separating the Winners & Losers”, 5/4/20), we discussed the high valuation of the market as another risk factor, but we did not spend much time discussing why the market is highly valued especially given the dire economic

backdrop. This week we will give you perfectly logical reasons why the market is richly valued, but this reasoning does not diminish the fact that high valuations are, and forever will be, significant risk factors.

This past week was full of bad economic data and mediocre earnings —and the stock market just kept going higher. The Dow Jones Industrial Average rose 608 points, or 2.6%, to close at 24,331. The S&P 500 index rose 3.5%, to 2930. The Nasdaq Composite beat both its peers, rising 6% to close at 9121, cracking the 9000 barrier again. The Nasdaq, amazingly, is up on the year, having tacked on almost 2,500 points, or 38%, from the March lows. Not bad, considering the damage that Covid-19 has wrought on the economy.

Earnings, however, are falling even as the stock market rallies. The S&P 500 is now expected to earn $128 per share in 2020, down from $152 at the beginning of the year. That would put the index’s forward 12-month price/earnings ratio at almost 23 times, among the highest ever, because falling earnings plus an epic rally equals sky-high valuation.

That is not quite the highest ever—the broad market once traded for about 26 times estimated earnings in 1999 during the insanity of the Tech Bubble era—but if some of the more bearish 2020 earnings estimates come to fruition, the market multiple could approach 30 times.

Why are Valuations High?

High valuations may be jarring, but they do not have to be concerning, thanks to the trillions of dollars being pumped into the economy by the Federal Reserve. Global investors will continue to pour money into the U.S. stock market if they continue to believe that the Fed and Congress will backstop its support. Investors believe that almost any U.S. investment is now safe. That is helping to draw in even more money as global investors flock to U.S. assets that are viewed as protected by the Fed.

Why Valuations May Not be as Much of a Worry

With this monetary support, this is not an illogical rally as investors anticipate that the second quarter of 2020 will mark the bottom for the economy. Based on that, stocks should be up now. Stock rallies do not end because investors, en masse, wake up and decide things are expensive. Something bad must happen. If currently held assumptions about the path of Covid-19 and the economy hold true and as expected the Fed stays true its word on providing continued support, the market should keep working its way higher.

We see S&P 500 earnings as high as $200 a share in 2022. At 20 times—the multiple we consider fair, given where interest rates are and the level of monetary stimulus—the S&P could be above 4000 in about a year, 36% above Friday’s closing price. It is an optimistic forecast, but it is not ridiculous.

Market Concentration Risk

Still, risks are lurking for investors. They always are. Market concentration is one. The Nasdaq is positive for the year, though roughly 75% of the stocks in the index are down in 2020. But the Nasdaq, like the S&P 500, is weighted by market capitalization, and larger companies count for more.

These days, the top 10 stocks, which include tech behemoths Apple (ticker: AAPL), Amazon.com (AMZN), Google (GOOGL) and Microsoft (MSFT), account for about 44% of all the value in the 2,700-stock index. And those 10-largest stocks are not cheap. They trade for about 47 times estimated 2020 earnings on average.

But this market is different from the dot-com tech wreck of the early 2000s, the last time valuations were this high. In fact, this time the highflying Nasdaq Composite holds the keys as to why investors can sleep at night. This crop of tech giants is quite different from those of the past. For starters, the tech sector now earns a lot of money, and businesses are booming. Microsoft CEO Satya Nadella said on his company’s recent earnings conference call that the virus has turbocharged companies’ digital transformation plans, boosting Microsoft’s cloud business, Azure.

Big tech also looks less economically sensitive than energy and industrial firms that were market giants long ago. It would be healthier if market leadership were more broadly based, but market statistics are always dominated by the largest companies.

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 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