Explaining the Market Response to Today’s Economic Distress

P erhaps the most commonly expressed take on stock market performance in recent months is shock at how the market has performed given the state of the “real economy.” For others, disgust is a better word — believing somehow that this market pricing in the face of double-digit unemployment and an economy not even fully reopened is somehow indicative of a growing class divide. I would rather spend more time on the former topic in this article, addressing what has really happened in the market since the COVID recovery began, and why. But some interaction with whether or not this is really evidence of class divide may be necessary.

The Dow Jones Industrial Average (DJIA) reached 18,213 in the middle of the day on Monday, March 23. In fairness, it was there for about a minute, and by the very next day had closed back to 20,704, but someone was selling at 18,213, and someone else was buying. Markets would stay between 21,000 and 25,000 until late May, comfortably off the March panic bottoms, but not yet ready to break out near the pre-COVID highs of January and February. Throughout the summer months, the markets experienced a few down days to counteract the up days (not many), but basically the summer was a sort of slow, steady grind higher, confounding the bears each step of the way, moving from the 25,000 level up to the high 28,000s where we find ourselves as of press time.

The story in the S&P 500 and Nasdaq is much more striking, but I used the Dow to illustrate market behavior for good reason. The S&P 500 has actually made new highs and then some, advancing over 50 percent from its March COVID lows, while the Nasdaq is up 70 percent from its COVID low (and more impressively, up 20 percent from its pre-COVID high). Both the S&P 500 and Nasdaq, though, are “cap-weighted” indices, meaning their aggregate price level is heavily weighted by the larger capitalization companies within the index. Because “big tech” names such as Apple, Microsoft, Amazon, and Facebook have seen such violent rallies to the upside in their stock prices, the entire index has been heavily affected by these few names. The Dow’s pricing methodology and sector diversification give it a little less sensitivity to this particular area, yet still appropriately reflect that activity (Apple and Microsoft are Dow constituents).

So yes, the market has been significantly hotter than many expected, leaving many to question if there is some sort of disconnect from reality here. I would propose five takeaways for you in an understanding of today’s market action relative to the muddled COVID economy.

1. The market is not as hot as you think. Now, this may seem totally counterintuitive or demonstrably false after what I have just written about the market index price action since COVID lows. But not all “facts” are “brute” or immune from context. That “cap-weighting” reality in the S&P 500 and Nasdaq are distortive, in that they paper over the fact that the five biggest names in the S&P are up roughly 50 percent, whereas the average stock in the index is still down on the year. In fact, 63 percent of the stocks in the S&P 500 are down on the year. The top five companies in the index (1 percent by number) make up a stunning 24 percent of the index by weighting. Those five names are up a whopping 42 percent more than the bottom 495 names in the index. The S&P 500 is composed of a staggering 37 percent in technology names when you add Google, Amazon, and Netflix to the S&P 500 Technology weighting.
2. The market is performing in line with how it has in past recoveries. But even if you do just take the disproportionate impact of big tech at face value, history has generally seen much of what we are seeing in 2020 — violent sell-offs followed by substantial rallies. In fact, this rally only represents the third quickest move to a new high following a bear-market sell-off in history (late 1980 saw a 27 percent decline followed by a 58-day move to a new high, and 1990 saw a 20 percent decline followed by an 86-day move to a new high). Even looking at the chart of this year’s recovery up against the 2009 market recovery, a striking correlation is immediately detectable. It is important to remember that the market’s significant rally in 2009 and 2010 was not led by a strong economy, either. Unemployment remained stubbornly high through both of those years, and home foreclosures would not begin to settle down until 2011. Markets were not rallying because things were good, yet; they were rallying because things had stopped getting worse.
3. Markets are always and forever discounting mechanisms. The biggest misapprehension under which some market observers labor is that market prices reflect what we see in the present. Markets are not pricing in what happened yesterday or what is happening today; they are pricing in what they believe about tomorrow. What happens today frequently affects expectations about the future, of course, but markets are always forward-looking. Markets may be wrong about how the economy will perform in Q4 of this year or Q1 of next year, but it is not entirely irrational to assume that the continued improvement in manufacturing data, capital-goods orders, new-home purchases, mortgage applications, auto sales, industrial production, retail sales, the national mobility index, homebuilder confidence, etc., point to an improved economic outlook. What will matter to market pricing in the months ahead is the same thing that has largely mattered these past few months — not the absolute performance of the economy, but economic performance relative to expectations.
4. One cannot ignore the role the Fed has played in repricing risk assets. The fact of the matter is that corporate profits will obviously be down in 2020 vs. 2019, and it may very well be that the market is assuming too much about profits recovery in 2021 (going back to my prior paragraph’s point about economic conditions, economic health is really only relevant to stock prices because economic health necessarily affects the outlook for corporate profits; stock prices are always and forever a discounted measurement of future profit expectations). But if the discount rate put on future profits is declining, the present value of those future profits is necessarily higher, even if the profits themselves are not. Put differently, the monetary environment in which we find ourselves is screaming for a higher valuation on risk assets, as the risk-free rate has been brought back down to 0 percent. In a world where the ten-year treasury yield offers 0.6 percent in yield, the historical 16x multiple of equity markets is of very limited relevance. 20x or higher seems high, and it is high historically (other than in periods that later proved to be frothy). However, the market multiple does not exist in isolation — it is a by-product of market pricing that is always relative to a key pricing signal — the risk-free rate. Holding down the fed funds rate to 0 percent (and by the way, seeing every central bank around the globe do the same — over 80 percent of global sovereign debt right now trades below a 1 percent yield!) boosts the valuation of risk assets, most notably the highly desired and widely owned U.S. stock market. But the impact of present Fed policy on the stock market extends well past the zero interest rate policy. In fact, rate policy has not even been the monetary tool that has most impacted markets. The explosive interventions into debt markets, either through direct bond purchases (quantitative easing) or liquidity provisions (commercial paper, corporate debt, asset-backed securities) has had an incalculable impact on equity markets. Besides the basic reality of $3 trillion (and counting) of new reserves in the banking system and liquidity that finds its way into financial assets far easier than it does the real economy, how significant is it to corporate profitability to have borrowing costs reduced to their lowest level in history? Fed interventions in the corporate bond market (shockingly, both investment grade and high yield) have created extraordinary access to capital for companies that know how to use that capital quite productively. This pendulum shift cannot be overstated — many companies went from challenging business conditions with high cost of debt and limited access to new debt that they needed for this difficult time, to instead, less challenging conditions with brutally low cost of debt and unlimited access to capital needed for this time and useable for growth measures after this time. That shift from “what could have been” to “what is” in credit markets is the most underappreciated factor driving equity markets today.
5. Last but not least, markets learned months ago the COVID impact would not be the huge “left tail” event many feared, or even close. Not only did markets determine by late spring that the American medical system would not be overrun by a black-swan event, and that millions of American people were not going to die, but by this summer — as the media inundated popular press with worries around new cases in Florida, Arizona, and Texas — markets had already accepted a reality that more and more Americans have come to terms with — this highly infectious disease most often creates very minor symptoms for healthy people under age 60, has a very low fatality rate compared with what was once feared, and has several very viable vaccine candidates on the horizon. This represents markets getting a rare opportunity to price in both a better present and a better future around COVID. The disconnect that many feel when they see stock prices is largely a disconnect from the media’s coverage of COVID, which has been reckless at best, and scandalous at worst.

None of this is meant to suggest market prices are not extended. Even if 20x P/E ratios are explainable in the present context, they are stretched to the outer bounds of those valuations. The market’s reliance on big tech, thus far, needs to end, and there is no telling if an inevitable correction in big tech will simply lead to a rotation to new leadership or bring all market sentiment down with it. Other risks certainly exist besides the obvious ones, too. We know unemployment is high and retail/consumer/travel/hospitality sectors are battered. But we also have a volatile election coming, the possibility of no clear winner on Election Night, and a remarkably polarized American electorate. U.S.–China relations were enough to drop markets ~20 percent in late 2018 (remember the trade war?), and the possibility of a flare-up in U.S.–China tensions is hardly off the table. There are known risks out there, and there are always unknown risks out there. This is hardly new, though.

In the end, U.S. stocks have performed admirably through this COVID crisis because the economic backdrop entering the COVID moment was strong, because expectations for the future are positive, and because the Fed has marinated the risk-asset landscape with abundant credit and cheap capital. Equity prices are not a slam dunk at these levels — far from it — but neither are they inexplicable or mysterious. What is inexplicable, though, is anyone ever forgetting the lesson of history most clear to astute market participants:

Never underestimate the market’s ability to embarrass or surprise.