Amid the flattening of the curve for new coronavirus cases, investors are starting to see a light at the end of the tunnel, in terms of being able to reopen the economy sooner. Stimulus efforts from both the Federal Reserve and the government have further eased economic concerns among investors. Consequently, they have pushed the S&P 500 30% above its March low, with many experts claiming that the bottom is behind us. However, the bulls may be getting a bit too optimistic regarding equities, with valuations once again stretched, and both sovereign and corporate debt ballooning.

Valuations are stretched once again

Prior to the coronavirus, the S&P 500 was trading at a 12-month forward PE ratio of around 19x. While the pullback had brought it down to more reasonable levels near 13x, following the swift bounce back up the forward PE returned to 18.5x. Moreover, this forward PE is based on an unclear earning picture ahead, as neither corporations nor analysts know how to forecast earnings for the next 12 months. Hence, earnings estimates may still not be fairly reflecting the hit from the coronavirus, which means the forward PE could actually be even higher than currently perceived.

Furthermore, another valuation metric is also signaling overvalued conditions in the market, and that is the ratio of the Total Market Capitalization (TMC) of equities to Gross Domestic Product (GDP), which currently stands at 129.1% (1.29). Any value above 100% (1.0) is considered overvalued, and a value above 115% (1.15) is considered significantly overvalued. In fact, with the GDP figure still not completely reflecting the impact of the coronavirus, the stock market valuation could actually be even more stretched than this ratio currently implies.

The chart below reflects the ‘Total Market Capitalization/ GDP’ percentage ratio since the 1970s.

(Click on image to enlarge)

Source: Gurufocus

The chart reveals how the valuation ratio prior to the recent coronavirus sell-off had surpassed even the height of the dotcom bubble, even crossing the 150% mark. In fact, even during the intensified sell-off in March, the ratio never dropped below 100%, implying that equities were still overvalued relative to GDP even at the March lows.

Contrarily, following the market crashes in the early 2000s and the 2007/2008 financial crisis, the ratio had collapsed well below 100%, reaching around 70% in September 2002 and around 51% in March 2009. Taking this into consideration, the claim by bullish investors that the recent market downturn was the buying opportunity of a lifetime seems far-fetched, with the TMC/GDP ratio remaining stubbornly above 100% (even higher considering GDP still doesn’t fully reflect COVID-19 impact).

One of the main reasons investors have been bullish on stocks recently is the unprecedented level of fiscal and monetary policy stimulus being witnessed by the economy.

Fiscal Stimulus

The US government’s stimulus efforts have mainly been focused on providing funding to individuals and small businesses, as well as particularly distressed industries.

The government is particularly trying to save small businesses, given the fact that according to data from 2019, small businesses employed about 47.3% of the US workforce. Hence small businesses going bankrupt would result in the unemployment rate skyrocketing.

Therefore, the government’s first stimulus package included $349 billion in loans specifically meant to help save small businesses, known as the Paycheck Protection Program (PPP). However, many small businesses have expressed difficulties in obtaining loans from banks, before the fund ran out of money completely. As part of a new stimulus package, the Senate is offering an additional $320 billion to replenish the PPP, “which provides forgivable loans to small business that keep employees on the payroll for eight weeks”. In order to overcome the issues experienced during the first round, “democrats also sought and won measures aimed at ensuring that businesses without relationships with major banks can get access to Small Business Administration assistance”.

While these measures should help ease the difficulties faced by small businesses, negative ramifications from the lockdown are already materializing, with over 26 million people filing for unemployment benefits over the past month. Investors should not naively believe that the unemployment rate will come down as quickly (or nearly as quickly) as it went up, even once the lockdowns end. We are not going to see the record low unemployment numbers (from prior to the coronavirus shock) that helped justify sky-high stock valuations, in a matter of a few months, as businesses will be confronted with debt repayment burdens as the economy restarts.

Outside of the US, after the pandemic is over, global governments will need to repay a mountain of sovereign debt, for which austerity measures will not be a popular solution amid an already badly hit economy. While reserve currency nations like the USA & EU can print money and monetize their debt to ease the burden, this is not an option for emerging markets, which will have a harder time repaying its debt (especially dollar-denominated debt).

Prior to the coronavirus shock, emerging markets already held $71 trillion in debt (both sovereign and corporate combined), implying a debt to GDP ratio of 220%. This ratio will only balloon further amid this crisis in 2020. This oncoming global debt crisis will certainly hinder the prospects of a swift global recovery, making it more challenging for American multinationals (with large international exposure) to recover their EPS and growth rates to pre-crisis levels.

Monetary Stimulus

The Fed has rolled out a variety of unprecedented measures lately to help stave off the negative economic impacts from the lockdown. Combined, the programs add up to about $6 trillion in liquidity to support the financial system and broader economy, which includes unlimited Quantitative Easing, buying commercial paper, supporting lending facilities for small and medium-sized businesses and most astonishing of all, buying both investment-grade and high-yield corporate bonds, to ensure firms of all credit qualities have easy and affordable access to credit amid the market turmoil.

The Fed’s decision to buy corporate bonds across the credit quality spectrum certainly helps prevent illiquidity issues, as firms are able to access debt easily at low-interest rates and thereby stay in business.

However, while these actions help prevent insolvencies in the short-term, over the medium to long-term, they are creating a debt crisis. While low-interest rates can help ease the burden, corporate bond issuers will eventually have to repay this mounting debt load. Thus the Fed’s bond market intervention will encourage a debt issuance spree among corporations while debt is cheap. However, this will also mean more debt (relative to income) will need to be repaid over the years to come. Repayment of these higher debt burdens will mean less capital will be available for Capex and expanding job opportunities, prolonging the economic recovery ahead.

Global debt rose to a record high of $255 trillion in 2019, which is 322% of global GDP. Amid an already highly indebted world, the coronavirus shock certainly will not help ease debt conditions in 2020, during which the global debt to GDP ratio is expected to hit 342%.

With the global economy awash in record levels of debt following this crisis, repayment burdens will impede governments’ and corporations’ ability to recover quickly from this crisis. As a result, large multinationals that make up the S&P 500 are unlikely to swiftly restore revenue and profitability levels back to pre-coronavirus levels. Therefore, it makes little sense for the S&P 500 to be valued at nearly the same multiple as it was prior to the coronavirus shock.

Bottom Line

While certain individual stocks have become attractive bargains, it is hard to argue that the overall stock market is currently a once in a lifetime buying opportunity, given that the TMC/GDP ratio currently stands at 129.1%. Amid the 30% bounce higher in the S&P 500 over the past few weeks, bullish investors are increasingly underestimating the aftermath of economic impacts from the coronavirus. The world was already awash with a record $255 trillion in debt prior to the coronavirus shock. With the pandemic stretching the global debt level (relative to GDP) even further this year, it will undermine the global economy’s ability to recover as speedily as the damage has been incurred, amid less capital being available for Capex and employment creation.