The S&P is down just 4% year to date and the Nasdaq is nearing record highs while the nation is grappling with a pandemic, protests, and unemployment not seen since the 1930s. The market “feels” divorced from reality, but that feeling might not be as accurate as your gut tells you. Let us explore the factors at play.
When the markets were at their lowest in late March that represented the height of uncertainty. Cities, counties, and states were locking down in what seemed to be random fashion. The federal government had not yet solidified any fiscal plan to tackle the oncoming economic tsunami resulting from industry shutdowns and mass layoffs. Reporting on the virus was varying widely. Death rates were soaring. And all of this was happening at lightning speed. Then things began to change – both materially and psychologically. First, the CARES Act was passed. This let people know they would be covered with unemployment insurance regardless of the type of job they lost, gave them an additional $600 per week, and promised checks of $1,200, in addition to support for small and medium sized businesses. Then the Federal Reserve stepped up and stated that they would supply unlimited liquidity (cash money) to keep the gears of the financial markets turning, including buying corporate bonds – essentially breaking the law to support the markets. The Fed has two mandates by law: maximize employment and stabilize inflation. They can do this through interest rate actions with member banks. They are not permitted to buy stocks or bonds (other than US Treasury bills). When the Fed stated it would intervene in the corporate bond market it had the effect of boosting asset prices in the high yield bond space immediately and without them even making any purchases yet. It also sent a very powerful signal to the market that the Fed will do whatever it takes to boost asset prices. With a sort of wink and nod investors took this to mean that the Fed would buy stocks if prices got too low. Since these actions, the stock market has not looked back. So, does the stock market not care that nearly 40 million people are out of work? The short answer is no, not really.
We have to remember what the stock market tracks. It tracks the value of the largest, best capitalized companies (often tech), and the amount of cash demand chasing after them. If there were an index of “all companies in America” it would probably be trading down some 70-80%. Who wants to invest in restaurants and hair salons with the nation on the couch? The service industry (food, lodging, etc) is getting crushed right now but Facebook, Google, Amazon, and Netflix are seeing solid profits. The problem is those kinds of companies employ a tiny fraction compared to the service and related industries. So even as Wall Street (Silicon Valley) hires and profits, Main Street can still struggle. And with added dollars in Americans’ pockets from the fiscal stimulus there is more than enough to make it back into the coffers of the tech giants.
But where do we go from here? As investors, we must always be looking forward. The April and May run-up in stocks were certainly looking to brighter days after the dark ones of February and March. Earnings estimates for 2021 are roughly 3% lower than 2019 (they are -30% for 2020, but who’s counting). Meaning that if the recovery goes about as expected, then companies should be earning roughly the same amount a year from now as they did a year ago. With interest rates near zero, this should bode pretty well for stocks. If things do stabilize this way, we would anticipate a rotation into some of the companies investors have shied away from recently, and expect smaller gains from the winners of the previous two months. There are some other considerations that cannot be ignored, however. For one, there is massive political unrest with protests in every major city. The cultural divide is at widths not seen since the 1960s and faith in institutions is waning. Additionally, these actions could set off a new wave of infection putting increased strain on the healthcare system and blow even larger holes in state budgets. There are also the rising US-China trade tensions and China’s recent national security actions aimed at taking more control over Hong Kong. Given how far we have come from the bottom and the tremendous uncertainty that still lies ahead (it is an election year after all) it would be prudent to temper expectations for gains like we have seen these past few weeks and remain invested in companies with solid cash flow and strong balance sheets. Keep in mind though, if we get a breakthrough vaccine sooner rather than later, we could party like it’s 1999.