Nations around the world quickly discovered that COVID-19 was a historic threat to public health. Few observers of financial markets predicted that it would end the longest bull market in history. Fewer still saw it creating the greatest 50 day rally in market history. With 40 million Americans out of work, restaurants, airlines and amusement parks (and everywhere else crowds gather) opening at a fraction of their normal capacity, a second wave of the virus likely in the fall and a trade war with China, the stock market is up 37% off its March lows!
What gives? Here are three questions that investors should ask themselves right now:
- What will the shape of the economic recovery look like?
- How much will companies earn in the future?
- Where will unemployment go?
While the answers to these questions are unknowable, because no one can accurately predict the future behavior of businesses and consumers coming out of a global pandemic, we can offer the following observations.
Clearly some of the rally is due to an improving economic outlook and return to normalcy. Investors are recalibrating their estimates for what the stock market will be worth in the future. However, that’s not the whole story. We believe a large part of the market’s rise (especially in the last month) is due to investors being willing to pay more today than they were a month ago for the exact same thing.
By paying more today, stock market investors are accepting lower returns in the future. Why would they do this? There are two major reasons:
- The Federal Reserve has de-risked the stock market. By acting quickly to pump trillions of dollar into the economy, the Fed has signaled it will stop at nothing to keep the economy and stock market afloat. As a result, investors are willing to pay more today for stocks because they see less chance of losing money. With less at risk, stock investors are paying more, and accepting a lower return in the future.
- TINA – There is no alternative. With the Fed dropping rates to zero, bonds and cash are offering little to no yield. The money has to go somewhere.
Where does that leave us? The market isn’t necessarily rising because a “v-shaped” recovery is in the cards. It’s rising because investors don’t see any risks to the downside. In our experience, that’s usually the case just before the bottom drops out.