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Stocks generate big gains and bigger questions

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The S&P 500 rose 20 per cent in the second quarter even though the pandemic is far from over, company earnings are sinking and public debt is expanding.

CONSIDER this opportunity: You can invest in a stock market that is greatly overvalued now but that could be only slightly overvalued next year if a lot of good things happen - during a time when a lot of bad things are happening.

Are you in?

This isn't a thought experiment. It's more or less the deal available to anyone buying stocks today, in the view of many analysts and fund managers. Judging from the market's performance, it's one that a lot of investors are taking.

The S&P 500 rose 20 per cent in the second quarter. With the pandemic far from over. With earnings sinking. With public debt expanding. With unemployment at multidecade highs and much of the economy still barely able to get up off the deck.

A bounce in economic indicators and stocks was expected at some point, given how far both fell after the pandemic took hold. But sceptics warn that further progress on either score may be much harder to achieve.

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"We've gotten the gains, now we've gone too far," said Tobias Levkovich, chief United States equity strategist at Citi Research. "What happens to the tens of millions of unemployed? Retailers are closing stores. Where do those jobs go?" Such questions may not be answered until after the November election, when the course of government policy should become clearer, Mr Levkovich said. Until then, banks may be reluctant to lend and companies may be reluctant to hire.

"There's still a fair amount of uncertainty, including the elections, including how we exit the pandemic," he said.

Saira Malik, head of equities at Nuveen, agreed that "there's a disconnect between the stock market and the economy". The good market news could prove fleeting, she said, if the latest spikes in infections produce significant increases in hospitalisations and deaths, and if consumers are less inclined to spend if they're still out of work and new government stimulus payments aren't forthcoming.

But widespread faith in the Federal Reserve has bolstered the markets. The Fed announced its intervention in March, through easy monetary policy and the purchase of financial assets with money created out of thin air. Many strategists applaud the Fed's short-term moves but are troubled by the long-term implications. "I'm not sure they could have done anything else in this scenario," Steve Kane, a bond fund manager at TCW, said. The Fed has signalled that short-term interest rates will remain close to zero for at least two years and promised to buy a virtually unlimited supply of debt instruments, from Treasury bonds to exchange-traded high-yield bond funds.

The Fed may have been forced to try to prop up the economy, and succeeded for now, but Mr Kane warned that "there's likely going to be a cost" for these actions.

"By not allowing the private economy to price risk appropriately, they're going to keep zombie companies alive," he said. "That will result in a less efficient economy and lower growth. Another thing that could happen is inflation could come out the other side if you have high structural unemployment and the government keeps spending."

Another source of bullish sentiment is a willingness to ignore the severe downturn and look "across the valley," as a newly popular phrase has it, evaluating investment prospects based on forecasts for a rosier post-pandemic environment.

The S&P 500 traded at the end of June at 24.4 times what analysts expect the companies in the index to earn this year, according to FactSet Research, compared with the average valuation of 18.8 times earnings over the last two decades. Using the forecast for 2021, which calls for a nearly 30 per cent increase in earnings, the index traded at 19 times earnings.

That 2021 valuation would be barely more expensive than the two-decade average, but a forecast is just that. Earnings indeed may bounce back sharply from today's levels, which have been depressed by the mandated shutdown of much of the economy, but there is no guarantee that they will.

Whatever valuations may be in the longish-term future, they sure look high now, and they never got all that low during the first-quarter sell-off.

"Valuations were higher at the March 2020 bottom than any other bear market bottom of the past 55 years, regardless of the measure", James Stack, editor of the InvesTech Research investment newsletter, wrote in a recent issue. "Not only that, but the subsequent rebound in the market has further exacerbated the existing valuation problems."

If the stock market is forming a bubble, it expanded mightily in the second quarter, to the benefit of fund owners. The average domestic stock fund rose an astounding 21.7 per cent, according to Morningstar, led by portfolios focused on industrials, consumer cyclicals, natural resources and especially technology.

Holders of international stock funds had to make do with an average gain of 19.7 per cent. Latin America and Asia specialists did the best.

Those performances contributed to the overvaluation that some analysts are warning about. Adding to the risk is the possibility that the valley in economic growth and earnings that bulls are looking across may be far wider than expected.

Economists at the UCLA Anderson School of Management stated in a report that the pandemic had "morphed into a Depression-like crisis". They estimate that the economy declined at a 42 per cent annual rate in the second quarter and predict that the lost ground will not be made up until 2023.

It's not just stock investors that are ignoring such warnings. The average bond fund rose 6.5 per cent in the quarter, propelled mainly by those that specialise in the riskiest issues. High-yield funds rose 9.4 per cent, and the ones that own emerging market debt were up 13 per cent. Long-term government funds were flat.

BETTER OUTLOOK

Although holders of safer government issues haven't had much to show for it lately, Mr Kane figures that the outlook is better for them.

"You're not getting paid to take that risk" in high-yield debt, he said. Treasury instruments, though, will benefit "if the Fed is going to do what the market anticipates, which is nothing on rates for a long time and in the near term support the market" with bond purchases.

But the near term won't last forever. After economic and commercial life get somewhat back to normal, the pandemic and the steps taken to mitigate its impact may be felt for years, maybe decades. The Fed's extraordinary actions are not the only potential source of trouble originating in Washington.

"We've seen a divided Congress with an unconventional president enact fiscal stimulus on a scale that is creating budget deficits that were inconceivable to prior administrations," said Chris Brightman, chief investment officer of Research Affiliates.

What's more, he fears that the extraordinary levels of government stimulus and intervention in the economy during this crisis may come to be expected, especially by younger generations. "We're going to see trillion-dollar deficits for years", he said.

All that could mean higher taxes and consumer prices, and uch lower corporate profits for years to come, he said. And with American stocks already carrying valuations higher than markets elsewhere, there "is a potential opportunity for those who want to limit equity investment in the US" and invest more abroad, he said.

Ms Malik at Nuveen favours foreign and domestic stocks alike, but only those of high-quality businesses. "Companies with strong free cash flow and resilient balance sheets will continue to outperform", she predicted. NYTIMES

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