May 10, 2020 | 04:45 pm
On Friday, May 8, 2020, the major indices (Dow Jones Industrial Average, S&P 500 Index, and the NASDAQ Composite Index) were all up about 30% from their March 2020 lows, reflecting an astounding rebound. Such exuberance appears to be at odds with the increasing number of infections, deaths, bankruptcies, and unemployed.
How can stock markets rise when every recent signal about the economy has not just been bad, but catastrophic?
A number of factors are at play.
The first is that stock market investors, and hence their markets, don’t care much about what has already happened. Rather, they tend to focus on what is going to happen in future. There’s an assumption that anything that’s already happened has been quickly digested by markets and transmitted into stock and bond price changes. Once those adjustments take place, what made those prices move is now “old news” which is no longer relevant going forward. Instead, market participants constantly look for signals and indications of “new news” which may lead to more asset value changes.
This theory or belief is an elegant way to explain changes in asset prices, but it does not guarantee that the level of prices at any point in time is correct. Let’s set that aside for now.
Returning to our original point, many investors seem to believe that the worst is over. Wharton Professor Jeremy Siegel exemplifies this sentiment with his recent bold declaration that “We’ve seen the lows in March and we will never see those lows again.” This crowd believes that all the disastrous implications of 20% unemployment, future reluctance to fly and shop, and the cost of dealing with virus resurgence have all been fully and accurately digested by the market. Their underlying assumption is that the effects of the virus, however horrendous in the near term, are temporary. They are convinced that we’ve seen the worst, and from here on things will consistently get better. This perspective allows for some minor retrenchment (decline in stock prices) but assumes steady improvement over time.
The Friday unemployment number was a terrible 14.7%, but since the market expected an even worse number around 16%, the newsworthy element was that things are not as bad as initially expected. The other bit of favorable new news was the sense that the combative rhetoric between China and the USA is cooling down. Combined, these two bits of news led to an increase in financial markets.
The second factor driving markets higher is that the investors who believe the worst is behind us have massive amounts of cash to spend. Many of them began to build cash piles several years ago with anticipation that the unprecedented bull market would eventually lose steam and create more favorable buying opportunities for forward-thinking opportunists. They were proven correct—although not for economic reasons.
The third factor is that financial institutions are flush with money, partly because they’ve made record profits in the last decade but also because they learned to fear liquidity risk following the financial crisis of 2008-2009. (We should also give some credit to banking regulators around the world, who forced banks to hold more cash reserves and thicker equity buffers.) As a result, we find ourselves in the fortunate situation of having a relatively healthy financial sector and we are not witnessing the cash-crunch that devastated our economy a decade ago.
Related to this is our fourth factor, the Federal Reserve’s commitment to do "whatever it takes." This unequivocal signal helped to ensure liquidity in the financial system in recent months and provides some forward-looking comfort that even if some other issue rears its ugly head in the near future, the Fed will be there to bail us out. The Fed’s commitment takes some risk off the table.
A fifth factor contributing to stock appreciation is that interest rates are still very low (flirting with negative territory). Depressed yields on fixed income securities (bonds) make stocks the only game in town with some hope of high returns.
Finally, some investors have been buying stocks reflexively, due to FOMO—fear of missing out. Afraid markets will continue to rise, leaving them holding cash, these investors have been piling into stocks in recent weeks.
In summary, there are a number of powerful forces propping up stock markets, and those forces are fueled by the assumption that recent declines are temporary and will not leave noticeable economic scars.
But what if the markets are wrong? Connecting this to my earlier comment, what if markets discover they are at the wrong level … that correct valuations are significantly lower, across the board?
That’s the $6 trillion question. If the real economy remains in a slump for an extended period, consumer demand and corporate earnings won’t recover quickly. Faced with an extended negative prognosis, investors will be forced to revise their expectations downward, with potential for sudden and steep drops in stock prices.
The coming months will reveal all.