How China's Recovery Is Unfolding

By Nicholas Jasinski |  Tuesday, May 5

Fed Fire Hose. The prevailing narrative on Wall Street remains one of optimism about the gradual reopening of the global economy from its coronavirus lockdown. But stocks closed today sitting on much smaller gains than they had for most of the session.

Comments from Federal Reserve Vice Chairman Richard Clarida got some of the blame for knocking the market's rally in the final hour of trading. Although he expects a recovery in the second half of the year, the Fed governor says the economy may need more support from monetary and fiscal policy.

The Fed can and does act independently from the prevailing political winds. But mustering the bipartisan support in Washington required for yet another huge spending bill could prove difficult in the months leading up to the November election.

The S&P 500 closed up 0.9%, after rising 2% at its highs of the day. The Dow Jones Industrial Average added 0.6%, and the Nasdaq Composite rose 1.1%.

Fiscal and monetary stimulus has played an immense role in financial markets' rebound from their March lows. The Fed's debt-buying programs have narrowed credit spreads and kept bonds liquid. Corporate debt issuance is high,  and the market appear to be healthy, with companies seeking credit able to secure it. And despite plans from the federal government to borrow a whopping $4.5 trillion in the current fiscal year, yields on Treasuries remain near their record lows.

As for stocks, weeks of gains came despite tumbling projections of corporate earnings, which have matched the grim economic data. Aggregate S&P 500 forward earnings estimates are down over 18% since earlier this year. The recent rally has stretched valuation multiples to above their pre-coronavirus levels.

The S&P 500 now trades for 20 times forward earnings estimates, above its recent peak of 19 in February 2020 and the highest level since 2002.

Investors looking past 2020 to a potential rebound in 2021 may be one reason behind the eye-watering multiple. Rock-bottom bond yields are another, as stocks become more attractive on a relative basis. But the Fed's immense quantitative easing has no doubt contributed to the stock-market rally, as have fiscal stimulus measures passed by Congress.

"All that matters is that fiscal and monetary policies have teamed up to provide the fastest and greatest economic stimulus and injection of liquidity in world history," economist Ed Yardeni wrote in a recent note to clients. "A trillion here, a trillion there adds up to massive policy stimulus."

According to RBC Capital Markets head of U.S. equity strategy Lori Calvasina, past periods of quantitative easing have also coincided with expanding P/E multiples for the S&P 500:

Multiples expanded the most around QE1, with both current-year and next-year P/E’s climbing 67% trough to peak. However, multiples also saw significant expansion around QE2, Operation Twist, and QE3, in the 20–49% range. So far in 2020, both the current-year and forward-year P/E's have climbed 31% since their March lows (using our 2020 and 2021 forecasts of $135 and $153). It’s possible that multiples have expanded even more, if our EPS forecasts turn out to be too high. More expansion is possible though not guaranteed.

In the last recession and bear market, S&P 500 forward earnings estimates fell 39% from October 2007 to May 2009, per Yardeni's data. If they follow the same pattern in 2020, they would drop from $179 in January to $110. That would put the S&P 500 at about 27 times earnings currently. If it continues rising to regain its Feb. 19 record high, the index would trade for 31 times that worst-case forecast. That would be fun.