Are U.S. Stock Prices Consistent with Their Fundamentals?

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The second quarter of 2020 saw massive gains in the major U.S. stock indexes. Granted, this was a bounce off a brutal first quarter, but the major domestic stock indexes are currently expensive relative to earnings. The tech-heavy NASDAQ index has been hitting all-time highs.

Discussions of the dissonance between stock prices and the economy are everywhere.

The U.S. equity markets are betting that COVID-19 will have little or no impact on earnings growth. The S&P 500 is down about 3% YTD (through the end of Q2) and the NASDAQ 100 is up by almost 17% for the same period. These changes are on top of stock valuations that were already high at the end of 2019 (as measured by the S&P 500 P/E and the Shiller PE10). From a fundamental perspective, the market consensus is for robust earnings growth.

The real economy looks rather different than stock valuations imply. The economic impact of COVID-19 is still unfolding, as the U.S. is in the midst of the second wave of infections. Meanwhile, the unemployment rate stands at around 13% (although the Bureau of Labor Statistics has not yet provided the updated value through the end of June). The percentage of working-age adults who have jobs is the lowest it has been for more than five decades. The International Monetary Fund (IMF) is predicting the worst global recession since the Great Depression. The economic data says that we should be revising our earnings outlooks dramatically downwards, which would imply that stocks should be selling at a discount relative to their pre-COVID levels.

How can we reconcile the dissonance between economic conditions and stock valuations? I offer four theories.