Why the stock market is beating expectations

 

In the early stages of the pandemic, the S&P 500 index dropped a third of its value. Since then it has roared back, soaring more than 50 percent from its low in late March and setting an all-time high last week. This seems very implausible when set against the current state of the economy and the ongoing devastation caused by the pandemic. So why is the stock market rallying in the face of a pandemic and bad economic news? Several explanations are plausible.

1. The stock market is not the economy: The stock market represents publicly traded companies only; it’s not the whole market. Most importantly, it’s always forward looking; i.e. it’s an indicator of the future earnings of those companies and how they would fare in the future. A rising stock market indicates that investors think these companies will do better in the future. On the other hand, a falling stock indicates that investors are pessimistic about the future earnings of companies.
2. Continued income support for the economy: For as long as the pandemic continues (or even worsens), the market is expecting stimulus checks, and enhanced unemployment benefits to continue coming. Even when a deal stalled in Congress, Trump signed an executive order to send more checks. Then there is the Fed which has been very accommodating. It pushed interest rates to zero and promised to keep them at record low for as long as needed. The Fed will also continue to print money and pump it into the economy because it doesn’t fear inflation. Continued income support for individuals and businesses allow the market to look beyond the adverse economic outcomes now. There is no risk in stimulus packages stopping anytime soon. It’s election season after all and politicians will think three times before stopping stimulus packages.
3. Optimism regarding vaccine development: Investors are looking past today's bad news and anticipating better conditions in 12 to 18 months. So far, the news on vaccine development appears to be reasonably positive. If a vaccine becomes available early next year, life will return to normal sooner than expected.
4. Better news from overseas especially China: The rest of the world, particularly China, have had much more success in containing the virus than the US. As cases continue to decline, China and Europe have moved fast to bring life & the economy back to normal. Stronger news overseas has helped push the US dollar exchange rate lower, providing a lift, especially to publicly traded firms that derive most of their earnings outside the US (China especially). China is a big factor that affects the US market - US companies rely heavily on China after call. The Chinese (and global) economic rebound is clear in the market as well. US stocks are actually underperforming the rest of the world. The US is following, not leading, a Chinese (and global) equity rally.
   
5. US equities are more about tech and industrials: The sectors most affected by the devastation due to the pandemic — restaurants, movie theaters, parts of retail — make up a small percentage of the US equity market and the economy for that matter. Indeed restaurants, hotels, and recreation services employ a very big proportion of the over one million people collecting unemployment benefits. However, the share of GDP for restaurants, hotels, and recreation services is less than 5%. US equities are more about tech and industrials. Of course high unemployment rate is a ticking bomb that will explode once the music income support for the economy stops.
6. Irrational investors: The CNN Business Fear & Greed Index is solidly in "greed" territory and some valuation metrics of the S&P 500 are well above historical norms. This indicates that greedy investors have been piling into the market. This is kind of expected because by slashing interest rates to zero and gobbling up trillions of dollars of bonds, the Fed has essentially forced investors to bet on risky stocks.

In short, it’s true that stocks are not the economy; however, they are not NOT the economy either. The US economy is certainly a reason to be cautious on US equities. For now, there is enough positive news for investors to remain optimistic and hence keep the market rally going. What do you think? Is the stock market “nuts” or the rally is justified?

Disclaimer: This post is merely my own assessment and is not an investment recommendation. For professional advice, seek input from a licensed investment advisor.