Second wave looms over stock markets and investors should be wary

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Given what we have seen in broad North American stock market indexes over the past six months, you could make the statement that COVID-19 doesn’t affect markets.

From the bottom in late March until recently, markets have risen steadily despite a backdrop of increasing global COVID cases. The explanation offered repeatedly along the way has been that the economy and the stock market are two different things. Besides, with lower interest rates investors would be foolish to bet against the Federal Reserve. On top of that, all of the significant government financial intervention would protect us from the worst impacts.

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Second wave looms over stock markets and investors should be wary Back to video

All of these comments are and have been true. I have said them myself and believe them. The question is can stock markets continue to rise when COVID-19 isn’t slowing down and may very well be getting worse? The answer is that it is increasingly unlikely.

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Back in July, we hosted a webinar with an epidemiologist. At the time, they said it was “almost inevitable” that there would be a second wave of COVID-19. The rationale was threefold:

First, COVID-19 is an active virus with no vaccine or significant treatment, so it is unlikely to just “go away.”

Second, while a first wave saw new cases slow meaningfully, it wasn’t eliminated. Reopening happened while there were still new cases every day. This almost guarantees a second wave, as behaviours returned that increase the spread of COVID-19.

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Third, the history of past pandemics shows that a second wave is almost always the case.

If we look globally, the number of new cases has continued to grow, with daily new cases regularly in the 250,000 to 300,000 range. Globally, there isn’t a second wave because the first wave never ended. Having said this, on a regional basis we are definitely seeing examples of second waves.

To get some sense of what we might face in Canada, it can be instructive to look at Europe, where numbers have meaningfully increased in the past month. If you look at Spain, they went from 10,000 new cases a day in March, to 400 new cases a day in June. Earlier this month they were back at 10,000 new cases a day. There can be no better definition of a second wave than those numbers. The good news is that the death rates have been much lower in this second wave (so far), with numbers 10 per cent to 20 per cent of what they were during the very dark days of March.

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The policy response in Spain has been much more muted than the first time around. There is definitely a strong reluctance to shutting down the economy again. There is also a strong reluctance from some citizens and local governments to follow tough rules after going through such a hard time earlier in the year.

In Canada, the number of new COVID-19 cases has grown meaningfully this month. The chart is looking more and more like Spain, although we never had as many cases at the top. Hopefully death rates in Canada will remain much lower than at their peak. How will Canada react to this second wave? Time will tell, but based on our culture and reaction to date, there will probably be a little more willingness to accept tough measures from the government, and to shut some parts of the economy down if deemed necessary.

So what does this all mean for stock markets?

We still have exceptionally low interest rates, which have been a significant driver of strong stock markets. We still have major government spending (which seems to have no end in sight) to help backstop individuals and many companies as they deal with economic challenges. The one thing that we have today that is of concern is that stock markets are currently trading at very high historic valuations. This doesn’t leave you with a lot of room for error. A second wave of COVID-19 in major economic markets could certainly be cause for error. Global trade fights could be cause for error. U.S. political and social battles could be a cause for error. This all makes us cautious even after a dip in markets, like the one we saw on Monday.

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When we talk about expensive or cheap stock market valuations, it is usually a form of price-earnings ratio. Essentially, this means that a company’s overall value is a multiple of its earnings or profitability.?A more refined version called the Shiller P/E Ratio was developed by economist Robert Shiller.

Historically, a Shiller P/E ratio of 30 or higher has been a very expensive number. In times with very low interest rates, it would make sense that these numbers would get higher, but even over the past three years, this ratio has ranged between 25 and 33.? It exceeded 32 at the beginning of September. At the same time, there is concern that corporate earnings growth cannot be maintained if we have more slowdowns caused by COVID-19 around the world. The Shiller P/E ratio is now back just under 30, but in this overall environment, we believe there is room for it to fall a little further.

After Monday’s sell-off, the U.S. tech-heavy Nasdaq was down 13.8 per cent from its level on Sept. 2.?The broader-based S&P500 is down 10.6 per cent.?The Dow Jones Industrial Average is down 8.2 per cent and the TSX is down 5.3 per cent.

We do not believe the declines are over.?For markets to get back to where they were on June 1, the TSX would have to pull back another four per cent, while the Nasdaq would have to tumble another 11 per cent.

We do not believe the declines are over

It is certainly possible that the declines don’t go that far, but we think there is a decent possibility that they will in the coming weeks.?Indices are now back very close to the mid-July levels that we believed were expensive at that time.

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As a firm, we do have some cash to invest at the moment, but we are now only dipping our toe in the pool in certain sectors. We are buying a little in utilities and consumer discretionary that we believe are cheap at these prices, but mostly staying on hold. Overall, we will likely be spending a meaningful amount of this cash between now and the end of the year, but mostly as we see some further declines.

We do see some good homes for cash in private credit investments that can take advantage of the high borrowing costs for corporations. Our focus for these investments is through the TriDelta Alternative Performance Fund, where we are aiming for returns in the eight per cent to 10 per cent range. Private credit investments have been quite solid throughout 2020.

We also see some opportunities in fixed-rate preferred shares, with Canadian dividend yields over five per cent and some price stability, and in gold as an alternative asset class given that cash is paying almost nothing and there are increasing concerns about the valuations and even stability of many major currencies.

As for stocks, we are getting a little closer, but mostly still keeping our powder dry.

Ted Rechtshaffen, MBA, CFP, CIM, is president and wealth adviser at TriDelta Financial, a boutique wealth management firm focusing on investment counselling and estate planning. You can contact Ted directly attedr@tridelta.ca.