O Ye, of Too Much Faith

Blind faith bulls are like cultists: they cling to their beliefs, despite evidence to the contrary. I suggest that you say “no thanks” to the Kool-Aid.

Yes, the economy will probably bounce back in 2021, but I doubt growth will be robust enough to justify these frothy equity valuations. Investors are placing too much faith in next year. The U.S. unemployment rate currently hovers at 8.4% and hiring is falling again, suggesting that any recovery will be sluggish at best. Another stock market swoon probably awaits over the near term. Below, I explain why and what you should do about it.

The three main U.S. stock indices opened strong Tuesday but pared gains in the late afternoon, in choppy trading. The Dow Jones Industrial Average closed essentially flat, after gaining more than 200 points earlier in the session. The S&P 500 gained 0.52% and the tech-laden NASDAQ jumped 1.21%. Stock futures Wednesday morning were higher in pre-market trading.

Stocks have recovered from recent swoons, fueled by a surge in mergers and acquisitions activity. Announced in recent days: Verizon (NYSE: VZ) will buy TracFone Wireless for $6.25 billion; Gilead Sciences (NSDQ: GILD) will buy Immunomedics (NSDQ: IMMU) for $21 billion; NVIDIA (NSDQ: NVDA) will buy Arm Limited for $40 billion; and Oracle (NSDQ: ORCL) plans to buy a stake in TikTok for an undisclosed sum believed to be $1 billion (pending U.S. government approval). That’s just to name a few of the notable deals.

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So what’s not to like? Well, the current disconnect between stock prices and corporate earnings is greater than at any time in modern history. If you’re not worried, you should be.

I shake my head at the unrestrained bullishness that I’m hearing lately on financial TV shows. Tune out the “analysts” on these gabfests. Cheerleading is for sports, not Wall Street. Stick to the hard data.

Second-quarter corporate earnings per share (EPS) growth for the S&P 500 came in at -31.7% on a year-over-year basis. The top performing sectors were utilities (+9.2%), health care (+8.3%), and information technology (+3.4%). Under current conditions, I continue to recommend utilities stocks.

The following chart, compiled with data from research firm FactSet, breaks down all 11 S&P 500 sectors:

For the third quarter of 2020, the projected year-over-year EPS decline for the S&P 500 is -22.4%. If -22.4% is the actual decline for the quarter, it will mark the second largest year-over-year decline in EPS reported by the index since Q2 2009 (-26.9%).

The energy sector is expected to report the largest year-over-year decline in EPS of all 11 sectors at a whopping -106.6%. The industrials sector is expected to report the second largest EPS decline at -63.1%, with the airlines industry the largest contributor to the decline for industrials, at -73%.

For Q4 and calendar year 2020, analysts estimate EPS declines of -13.0% and -18.5%, respectively. And yet, stock prices have rallied (with dips along the way) since late March.

One reason for the disconnect between stock prices and earnings is the fact that bond yields are low. The benchmark 10-year U.S. Treasury Note currently hovers at 0.67%. Investors don’t see an appealing alternative to stocks.

The stock market is forward looking, so the important question is, what sort of earnings performance do analysts expect for next year?

Analysts project EPS growth of 13.2% for Q1 2021 and 44.2% for Q2. But a lot can happen between now and the start of 2021. What’s more, investors are looking to the 2021 economic “recovery” with excessive optimism. The current recession is severe and it could linger into the first half of next year. When unemployment of 8.4% is considered okay, we’ve set the bar pretty low.

The winners and losers of COVID-19…

The non-partisan Congressional Budget Office’s latest economic projections call for U.S. gross domestic product to shrink 5.9% in 2020 and grow 4.8% next year on a fourth-quarter-to-fourth-quarter basis. But we’re in uncharted territory and those forecasts could easily get revised downward.

Even if the pandemic wanes in coming months, millions of consumers will be reluctant to pursue their customary behaviors. Some industries, such as digital work-at-home platforms, are benefiting from the pandemic and they’ll be in even stronger shape when the virus finally disappears. Other industries, such as airlines, theme parks, restaurants, and sporting events, will take many months if not years to return to pre-pandemic levels.

E-commerce is booming, but shopping malls are ghost towns and most will never recover. Streaming video is all the rage, but multiplex movie theaters appear doomed. Wall Street is thriving, thanks to the good fortunes of a handful of Big Tech stocks. But the pandemic has wrought permanent economic carnage on Main Street.

The changes in my own behavior serve as a microcosm of the economy’s demand destruction. I enjoy beer, baseball and movies, but even when the pandemic ends, I’ll be far less inclined to visit bars, ballparks and movie theaters.

The final months of 2020 are fraught with peril. If there are setbacks, such as a deadly resurgence of the pandemic during the winter flu season, future earnings and economic projections could tumble due to reimposed business lockdowns and the demoralization of consumers.

There’s also a good chance that the November presidential election will be disputed, resulting in lots of partisan vitriol and maybe even street violence. Sad to say, the American political scene lately resembles that of a banana republic. If we wake up on the morning of November 4 without a clear winner (which is entirely likely), you can expect wild market volatility and a sharp rise in gold prices. Wall Street hates uncertainty and not knowing who was elected president would probably tank the stock market.

I continue to strongly recommend gold, as a hedge against crises. Gold prices have soared this year and they probably have further to run. All of the risks that I’ve just outlined in this article suggest that you should increase your exposure to gold.

Put your faith in the yellow metal. For the latest details about our favorite gold investment, click here.

John Persinos is the editorial director of Investing Daily. Send your questions or comments to mailbag@investingdaily.com. To subscribe to John’s video channel, follow this link.