Riding on a high
The US National Bureau of Economic Research (NBER), the official tracker of the US business cycle, declared this week that the recession in the country started in February 2020. According to NBER February was the peak of the business cycle as jobs already started disappearing (even though the huge COVID-driven unemployment claim spikes didn’t happen until mid-March). Since then over 42 million Americans found themselves out of work. The official unemployment rate shot up to 14.7% in April, and has declined back to 13.3% in June, as a more encouraging sign of a recovery driven by business re-openings.
Due to the effects of COVID-19 the uncertainty in the economy is still huge, biggest it has ever been according to the Economic Policy Uncertainty Index. Almost every graph we see during the pandemic has a label “unprecedented” attached to it; we are usually looking at a very steep exponential curve facing up (for unemployment, uncertainty, or fear), or down (for business and consumer confidence, or future expectations). Our own Fear Reaction Index (FRIX) is also showing a huge spike in negative expectations of businesses and consumers across Europe and the US. People are changing their behavioral patterns and are still voluntarily limiting their mobility and hence their spending (less traveling, lower exposure to live events, spending less time in restaurants, etc.) while at the same time many are finding themselves in a situation where their jobs are unsafe, which is forcing them to cut down all non-essential spending (like taking loans to buy a car, go on holiday, or refurbish their flat) to brace for an uncertain future.
At the same time, during this “era of unprecedented events”, the stock market is almost completely deaf to all the uncertainty and volatility. It did react by the end of February and early March, when it lost 34% of its value from its February 20th peak. This decline lasted for about a month, after which on March 23rd it started bouncing back. And it bounced back astonishingly: the S&P500 saw the best 50-day upsurge in its history, up 44% from its trough.
Just as the majority of the population across the US and Europe were starting to adapt to a life in the quarantine — which at the time no one had an idea of how long it might last — the market started growing robustly and two and a half months later it completely reverted the entire February/March decline. It is now net positive for 2020. All this amidst extremely negative expectations from both consumers and businesses of the months to come, where many jobs will be lost and GDP is projected to go down between 6 to 8% (in the US). In addition to all of this, the US is engulfed in Black Lives Matter protests around the country which do not seem to subside any time soon and are likely to cause another disruptive effect on the economy.
How can this be? Why is there such a stark divide between the real economy which is struggling and is expecting a very turbulent second half of 2020, and Wall Street which is riding on a high? Is the market extremely overvalued or is it on point as it correctly factored in the initial uncertainty regarding the pandemic already in February/March and is now simply looking forward to a very fast (V-shaped) recovery?
There are three major explanations:
- The market is riding on a huge monetary and fiscal stimulus
- Future expectations of a quick post-COVID recovery
- Asymmetric effect between publicly-traded companies and SMEs
Let’s examine each of these:
1) Riding the stimuli
It is no coincidence that the market started rebounding just as Congress passed the $2 trillion stimulus package in March, the biggest in US history, a lot of which was oriented towards bailing out big companies like the airlines. Even more important than the fiscal stimulus was the monetary one enacted by the Fed, which decided to once again slash its federal funds rate down to 0.05% in April, opening up room to a $6 trillion injection into the economy through credit and lending programs. This is much bigger than the stimuli and bailout packages administered back in 2008 and 2009.
Low interest rates allow companies to borrow money at low costs which typically fuels a stock market boom. Investors in that case do not want to buy bonds which will give them low yields, but are instead opting for stocks. Even in a situation where the future is highly uncertain an investment in equities offers a better return than an investment into bonds or currencies. And the Fed is giving a powerful signal that the rates will remain low for as long as it takes which to an average investor is a clear sign to buy equities.
2) Exuberant future expectations
Stock markets are all about forecasts. Collective forecasts of all investors looking 6 to 12 months ahead. When it’s going up it is because investors, the majority at least, are collectively expecting the economy to bounce back quickly and adapt to the pitfalls of the pandemic (the quarantine, restricted mobility, etc.). While the initial bounce-back was entirely driven by the Fed and the federal government, the continued rise of the markets in May and June was down to optimistic forward-looking expectations: firms will successfully adapt to the pandemic, the reopening will see things return to normal rather quickly, and a vaccine will be found sooner than expected.
When such expectations become prevalent among the majority of investors the markets very easily enter a frenzy and a lot of investors starts buying in, worried that they will miss out on the great opportunity. It doesn’t matter if their expectations are unrealistic or if they are based on miscalculations over the impeding threat of the virus and an inability to understand fat tailed distributions of things like pandemics (such as will there be a second wave in an environment where the virus is still spreading fast globally, particularly in the Americas, in Africa, and in SE Asia). As long as everyone is buying, time is ripe to enter the market. This logic has time and time again been proven wrong and has very often ended with a negative effect on investors’ finances. At least for the small investors.
3) The firms driving the markets vs the firms that are shutting down and laying off
Which firms in the US have disproportionaly represented the growth in the stock market over the past decade? Big tech companies. Five tech stocks account for 20% of the overall market value of the S&P500: Apple, Amazon, Alphabet (Google), Microsoft and Facebook, all of which, except for Facebook, have passed the $1tn valuation. These companies that have seen a huge rebound in market value over the past few months (see graph below) as investors see them as the big winners of the pandemic where more and more things will be switching online. Even the smaller tech stocks of companies like Zoom or Netflix were reaping huge rewards from people staying at home and using more of their services.
Even though not all tech companies have experienced an upsurge in sales, the markets are all about expectations, and expectations are that things are moving online faster than ever. This is the “new normal”. It is thus no wonder that tech companies’ stocks are benefiting from an upsurge in demand for online services.
On the other hand, companies laying people off have mostly been micro, small and medium-sized businesses who were hit hardest by the pandemic as they had to close shop during the lockdown. This is where the unemployment spike happened but since none of these companies are listed on the stock market their relative performance is not factored in. Not yet at least.
Other companies that were laying people off were airlines and the hospitality industry, but in their case the major players have been bailed out by the government while their stock prices have been moving up in recent weeks. This is a powerful sign of irrational exuberance; many of these companies have had cash flow problems even before the pandemic, and are now piling up a lot of debt which should hurt their future prospects and send their prices down, not up. Airlines are in for a very rough couple of years. It should be the last thing on an investor’s list to buy right now.
Is the market right and what happens next?
The forward-looking expectations on the stock markets right now which are driving indices up are disregarding several factors that are contributing to a bleak outlook of the economy.
First, aggregate demand is very likely to keep going down. The effects of the pandemic are going to be felt in months, even years to come. Many companies that survived the initial blow might not do so in the coming months which will further decrease confidence and depress demand. People are changing their spending behavior and are postponing all major nonessential purchases. It is a matter of time before this depressed demand spreads through the economy and by then it will even impact the tech stocks’ performance (although certainly to a much lesser extent than other industries).
Second, the government’s stimulus will run out as it will soon have to start worrying about rising debts and deficits. During the heyday of the pandemic the measures have been implemented with a clear indication that we will deal with debts and deficits later, once the economy is saved. This “later” is coming up quite soon which is seriously undermining all expectations of a V-shaped recovery.
Third, the virus is still spreading globally at very fast rates as it is hitting South America, Africa and South East Asia. Given that there are no more travel restrictions it is a matter of time before it resurfaces back in the Western hemisphere. It is obviously impossible to predict whether there will indeed be a second wave but not many companies are prepared in case it does happen. In other words, we are collectively still exposed to another big shock and do not have any hedging instrument or insurance policy as protection. We cannot know for sure whether it will happen but we can take measures to benefit from the shock. Hardly anyone is doing this.
Taking all this into account we can cautiously claim that the “market” is not right. It is being driven by exuberance which will end soon. No one can predict when this will happen which is why it is a good idea to already start building a strategy of how to benefit from another potential downturn. Even if it never happens.