Bull market rules

That’s because at the March 2009 bear market bottom I was slow in realising that QE was a gamechanger. In fact, it took me a full three months to move from a defensive bear strategy to become a market bull. I vowed never to repeat that mistake, and to have a plan in place to profit from the next round of QE as and when it arrived. To do so I studied the QE monetary transmission mechanism to such a degree that I dedicated a whole chapter to the subject in my book Stock Picking for Profit, specifically to pinpoint likely stock market winners and losers (table below) when the central banks next flooded financial markets with liquidity. What I couldn’t have imagined was that a global pandemic would be the catalyst.

But that frankly doesn’t matter, what matters is to be on the right side of the equity market, and one that is shaping into a new bull market after the briefest of bear markets. This explains why I have not advised selling a single stock in the past 11 weeks and have recommended buying into all bar a few of the companies I have written about. Some of the share price gains have been eye-watering, and with good reason as there are major factors at play here driving equities higher.

■ Sentiment changes from recession to recovery. It may seem bizarre that global stock markets can recover more than 80 per cent of this year’s losses – both the S&P 500 and Dax 50 are now within 7 per cent of their all-time highs, for instance, after respective 35 per cent and 40 per cent drawdowns – while the world battles against a global pandemic, an unprecedented economic downturn, and civil unrest, too.

However, as I noted in my column (‘Stockpicking for bear market gains’ 18 April 2020), the stock market is forward looking and acts as a discounting mechanism to arrive at fair value for companies after factoring in the magnitude and duration of the likely earnings downturn, and the nature of the subsequent economic recovery. At the time, the expectation was for a rebound in the third quarter of 2020 after a dramatic collapse in second quarter output. It still is.

Moreover, the stock market has a strong tendency to bottom out around three months before the economy does, as has been the case in nearly all other recessions, another area of economics I have studied in detail. The implication being that following the dramatic sell-off in February and March, and based on the assumption that lockdowns would be eased by the summer (which clearly is now happening), then it was only rational to expect investors to change their risk averse recessionary mindset in advance of the economic recovery phase to one that is focused on the potential investment upside from a risk-on recovery. That’s exactly what investors have been doing. Of course, they needed a catalyst for the change of mindset.

■ Unprecedented QE programmes. All the major central banks have launched game-changing QE programmes.

The Bank of England has committed to a £200bn QE programme (9 per cent of UK GDP) to lift its holdings of UK government gilts to £645bn and the European Central Bank (ECB) has unleashed a €1.35 trillion (£1.2 trillion) bond bazooka (12.6 per cent of eurozone’s GDP) to offset a forecast 8.7 per cent contraction in the currency bloc’s economy this year.

The US Federal Reserve has gone one step further, announcing a QE infinity balance sheet expansion through “purchases of Treasury securities and agency mortgage-backed securities in the amounts needed to support smooth market functioning and effective transmission of monetary policy to broader financial conditions”. Factor in the Federal Reserve’s maiden move into corporate bonds through the purchase of investment-grade securities in primary and secondary markets and exchange-traded funds, and many other measures, too, and the US central bank is on course to double the size of its pre-Covid-19 crisis US$4.3 trillion (£3.4 trillion) balance sheet. Japan’s central bank has doubled down on stimulus, too, unveiling a ¥117 trillion (US$1.1 trillion) package in May.

In aggregate, the G10 countries and China have announced total government and central bank stimulus programmes worth US$16 trillion and rising, a hefty sum in relation to the World Bank's $9 trillion estimate of lost global economic output this year. Importantly, ramping up QE will help soak up the additional sovereign debt issuance resulting from Covid-19 pandemic-induced budget deficits and the huge fiscal stimulus packages of governments.

It's worth remembering that the primary aim of QE is to drive long-term bond yields lower, force investors up the risk curve in search of higher returns, relative to bonds, boost asset prices and create a positive wealth effect. But this is more than simply a liquidity-driven process as cheaper money is being recycled directly back into the real economy to support investment.

As was the case during previous QE programmes, equities are a major beneficiary, even more so now given that the yield alternatives are woefully thin on the ground for fixed income investors in a zero-interest rate policy (Zirp) environment. This factor and the scale of the money printing programmes are the primary reasons why I expect equities to perform even better than they did during the US Federal Reserve’s first instalment of QE. To recollect, the MSCI World index soared 39 per cent between November 2008 – when chairman Ben Bernanke signalled the US central bank’s intention to pursue this line of monetary policy – and March 2010 when QE1 ended. The FTSE 350 performed even better, rising by 43 per cent.

■ QE creates dollar weakness. One consequence of the Federal Reserve’s QE programme is to drive strong capital flows overseas – which can be seen in rising foreign exchange reserves. In turn, emerging market authorities tend to print domestic currency to buy US dollars, to prevent excessive currency appreciation. This raises deposits at banks, inducing a lending boom, which is commodities intense – bullish for commodities, with knock-on effects on commodity currencies and speculative flows.

Movement of capital flows overseas is important because the offshore US dollar non-bank lending market is worth US$18 trillion, a sum equating to around a fifth of global GDP. This market had been under increasing stress following a 15 per cent appreciation in the US dollar index in the preceding two years before the stock market crash. Moreover, banks outside the USA have dollar debts exceeding the total liabilities of those banks operating within the US, so their funding is vulnerable to any dollar liquidity shock.

That’s exactly what happened in March as financial markets became dysfunctional. However, the massive injection of liquidity into the global financial system alongside the Federal Reserve’s barrage of new liquidity programmes (to help keep the market functioning) has eased financial stress and cut debt servicing costs of corporate borrowers, too.

It’s no coincidence that the US dollar has declined almost 6 per cent on a trade weighted index since the US central bank announced its QE infinity programme. I expect the greenback to continue to weaken as the Federal Reserve dramatically increases the supply of dollars in circulation.

■ Recession, but not a depression. The concerted fast response of governments to offer financial support to companies has prevented unemployment levels rocketing to Depression levels. In fact, authorities may have done too much already as US employment data for May revealed 2.5m net additions, rather than the 7.5m losses some economists had been expecting, to lower the unemployment rate from 14.7 per cent to 13.3 per cent.

Of course, that’s still 10 percentage points higher than at the start of the year, representing 16 million net new claimants. However, a high percentage of these temporarily unemployed workers are being re-employed as the lockdown ends, which explains why economists are predicting an 8 per cent rate by the year-end. In the UK, the Bank of England is forecasting a 9 per cent unemployment rate. Those outcomes are far better than investors had previously feared.

■ Productivity gains. Covid-19 has changed the way we work and live, accelerating changes in the workplace and boosting productivity. For instance, companies are looking at their property requirements as flexible home working becomes more common. Technology is playing an important part, too, greater use of cloud computing and virtual conferencing are just two examples. Lower and more flexible cost structures will improve the operational gearing of companies during the recovery phase and their profitability in the future, too.

■ Consumer spending. In both the UK and USA the consumer accounts for over two thirds of GDP. Not everyone has endured a bad time.

For example, around 21m (61 per cent) of the UK working population have been unimpacted by the crisis and there are 12m retirees, too, all of which have been unable to spend during lockdown, a key reason why consumer saving rates have rocketed. Also, millions of the 8.7m furloughed staff and 2.3m self-employed in receipt of government grants are now returning to work. Cumulatively, there is significant pent up consumer spending that will help drive the economic recovery. It’s a similar situation in the US. In fact, enhanced unemployment benefit payments mean that millions of the country's temporary unemployed now being rehired were better off not working.

It’s worth noting that the oil price has surged since hitting a multi-year low on 22 April. Brent Crude has more than doubled to US$42.88 a barrel, albeit it is still down more than a third this year. Economic benefits of a cheap but recovering oil price are two-fold: low transport and energy costs (good for both consumers and companies); and reduced financial stress in the oil sector (positive for the banking sector).

■ Technology and small-caps sending strong signals. Since global stock markets troughed in late March, the FTSE Aim All-Share index has rallied over 50 per cent and is down only 5.7 per cent for the year. In the USA, the Nasdaq 100 is at a record high, up 12.5 per cent for the year.

Technology and small-caps leading the rally indicate much improved investor risk appetite, and highlight the broader based nature of this bull run. That's important.

■ Earnings set for recovery in 2021. The S&P 500 benchmark is trading on 19.5 times 2019 earnings and bottom-up EPS estimates for 2020 point to a 28 per cent lower outcome against prior forecasts, according to analysis by Factset. The previous record downgrade was 26.4 per cent in the first five months of 2009.

In other words, the 35 per cent sell down in the S&P 500 was not out of sync with the downgrade in 2020 earnings, as has been the case in previous bear markets, adding weight to the view that the market low was in March. Interestingly, the pace of earnings downgrades has slowed markedly, another positive as investors position for a V-shaped earnings recovery over the next 18 to 24 months. Consensus is for earnings to return back to the 2019 high watermark in 2021, hence the turbo charged stock market rally.

Riding the recovery phase

Of course, risks abound and many investors have been scarred by the stock market crash. For instance, there is a divergence of opinion between strategists at some the largest US investment banks. But that’s good because if everyone is bullish then where are the new buyers going to come from? It’s when the final bears throw in the towel that the bull run is over. That’s not likely for some time as you need to give cautious investors time to re-adjust to the new investment paradigm. This is a favourable backdrop for stock picking in my under researched small-cap space, a task I am relishing.

■ Simon Thompson's latest book Successful Stock Picking Strategies and his previous book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 to place an order. The books are being sold through no other source and are priced at £16.95 each plus postage and packaging of £3.25 [UK].

Special offer: Both books can be purchased for the special price of £25 plus discounted postage and packaging of only £3.95. The books include case studies of Simon Thompson’s market beating Bargain Share Portfolio companies outlining the investment characteristics that made them successful investments. Simon also highlights many other investment approaches and stock screens he uses to identify small-cap companies with investment potential, too. Details of the content of both books can be viewed on www.ypdbooks.com.

Simon Thompson was named 2019 Small Cap Journalist of the year at the 2019 Small Cap Awards.