This Insights article was contributed by Dr. William Sackley, Director of BB&T Center for Global Capitalism and Cameron School of Business Professor of Finance.
 
The stock market, as gauged by the S&P 500 index, just completed its strongest calendar quarter of appreciation during the 21st century, albeit following a dismal first quarter. At this writing, the index is down just over 4% year-to-date, or just over 8% from its February high. That is fairly amazing in the presence of a global pandemic that appears to be escalating rather than abating in the U.S., and which has resulted in a larger disruption of economic activity than during any downturn subsequent to the Great Depression. Should investors be complacent about their equity exposure at this point, or “heading for the exits?”
 
Indications are that significantly fewer investors shifted out of equities during the February-March decline of 34% than occurred during either the dot-com crisis (circa 2000-2002) or the Financial Crisis (circa 2008-2009). Does this indicate that investors are becoming less emotional in the face of market volatility, perhaps because the market recovered from the Financial Crisis relatively quickly?
 
Using only price levels, as opposed to including dividends or adjusting for price levels, the Dow Jones Industrial Average (the S&P 500 was yet to be created) took 25 years to recover following the Great Depression. Again using price levels, the NASDAQ, hardest hit of the indices, took up to 15 years to recover from the dot-com crisis.

For the Financial Crisis, the S&P 500 required only between five and six years to recover its prior level. Perhaps more important, the Financial Crisis introduced investors to a Federal Reserve that was more accommodating than in the past, specifically in the level and duration of targeted (short term) interest rates, and accompanying asset-purchase programs. Have investors grown to believe that the overall risk of equity investing has been slashed by the Fed’s proclivities?        
 
The Fed’s balance sheet, still inflated from the Great Recession, is up approximately 70% during 2020, and Chairman Jerome Powell has all-but-promised that interest rates will remain untouched for the next two years. The liquidity injected into the economy has to go somewhere, and a fair amount ends up in the stock market, especially given that bond yields point to negative real rates of return.
 
But wait! Perhaps the Fed has had exerted less influence on asset prices than surmised. Possibly current market levels can be explained through the stock market’s forward-looking nature – thought to focus on the expected environment approximately five months into the future. By that time, we could conceivably have an effective vaccine. By that time, we should know the outcome of the Presidential election.

As this is being written, the second consecutive stronger-than-expected monthly jobs report was just released (2 July: +4.8 million jobs, following May’s 2.5 million increase). Perhaps a speedy recovery is still in the cards – the proverbial “V-shape” rather than something akin to an “L-shape.” Indications appear to be building, however, that further recovery could be considerably slower than recent jobs reports inspire. Forecasting risk seems to be slanted to the downside.
 
So how can we decide whether the current level of the stock market is justified or “atmospheric?” Here are some factors favoring “justified.”

• The Fed is unlikely to “remove the punch bowl” from this party for quite some time,
• At least one metric shows the market to be undervalued, namely, the Fed model. This metric compares the earnings yield, that is, the inverse of P/E ratio, to the 10-year Treasury yield. Note that, despite the name, this model is not endorsed by the Federal Reserve,
• Prior to the pandemic, the U.S. economy was extremely strong, even if not exhibiting rapid growth,

• It is entirely possible if not likely that recent market lows (23 March 2020) will be retested, whether due to delayed vaccine, election outcome, or social unrest,
• Most valuation models show the market to be overvalued (e.g., forward P/E, Shiller’s Cyclically Adjusted P/E ratio)…especially given the still declining level of the ‘E.’
• Fairly narrow price leadership, as exhibited by six tech stocks (Facebook, Apple, Amazon, Netflix, Google, and Microsoft representing 24.5% of S&P 500 market capitalization (26 June 2020),

• Your time horizon: If you do not anticipate tapping your accounts for at least five years, most analysts are likely to suggest remaining invested. Many economists expect our economy to have returned to somewhere near normalcy by third quarter 2021,
• Diversification: Do not be tempted to “stretch for return” by avoiding a diversified asset portfolio. True, fixed-income yields seem abysmal at this time, but several categories of fixed-income investments have outperformed equity over the past 20 years. According to conventional wisdom, that should not occur – and it certainly does not have to continue. But this lends credibility for investors to adjust their priors regarding asset-class risk and portfolio diversification.
• Risk tolerance: Have you reevaluated whether your asset allocation or your investment objectives need adjustment? The current market environment holds the potential for significant volatility. Yet most investors determine their risk tolerance through surveys taken during times of relative market tranquility…suggesting that their risk tolerance is typically exaggerated. Now would be a good time to reassess your stress-tested level of tolerance.