While the Fed has been brilliant in addressing the economics of Covid-19, they are simply addressing the symptoms, not offering a cure, reports Al Brooks.
Since late last year, I have noted that the two-year trading range would probably continue all year. This is still true. In fact, the stock market will probably be in a trading range from 1800 to 3600 for the next decade.
However, I keep making the point that this was due to the extreme buy climax that ended in late 2017 and not the pandemic. The pandemic simply unleashed what was already going to happen. The market was just waiting for a trigger.
But the pandemic will still be very important over the next year. It has significantly changed consumer habits. Consumer spending is responsible for 70% of the GDP. Are you going out to dinner or traveling as much as last year? How often have you been to the mall in the past two months? How much have you driven lately? We all are spending less.
The huge surge in unemployment is further reducing the GDP. These changes will not return to normal for many months after a vaccine. Therefore, the pandemic will continue to hurt economy for at least another year.
The Fed has been amazing
As many of you know, I have been critical of Fed Chairman Jerome Powell because he appeared to be intimidated by President Trump. However, he and the Fed have done an extremely good job with this catastrophe.
The market is rallying because it was oversold and because everyone loves what the Fed has been doing. It continues to release a series of nice surprises that greatly bolster consumer confidence.
But as I have been saying, all they are doing is preventing a disastrous problem from destroying the economy. They are treating the problem, but they cannot fix it. There is a limit to how far the rally can go, given that the pandemic will keep the economy weak for at least a year.
What happens when the Fed stops?
Part of the rally is a bet that there will be a next nice Fed surprise. At some point, the Fed will be finished. The part of the rally built on the expectation of more surprises will stop. Those traders will not only stop buying, they will begin to take profits. I doubt the Fed has enough surprises lined up to take the market back to the old high.
More importantly, the forces behind that 2017 buy climax will be with us for a decade. Therefore, even though the Fed is averting a depression, it will not be able to make the economy healthy again.
A new high would result in a very overbought P/E ratio
The price of the S&P 500 index relative to the average earnings of the stocks in the index (P/E ratio) was 25 in early February. That is at the high end of the historical range. The average is around 19.5. Earnings will be far below normal for many months and probably the remainder of the year.
What happens if the stock market gets back to the February high this year? This time, that price would be relatively much more expensive because the earnings will be so much lower. The P/E ratio would be extremely overbought. Fewer institutions will be willing to pay that price for those earnings.
How many people want to pay a high price when the average company is not earning much? I will let someone else buy up there. I will be looking to sell.
Since late 2017, price has been too far ahead of fundamentals. It typically takes a decade for the fundamentals to catch up. The 2020’s will probably be similar to the 1970’s and the 2000’s. Traders should expect sideways price action with big rallies and selloffs for the next 10 years.
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