If you are like the many people I talked to over the spring and summer months, you might be questioning the rationality of the stock market. Millions of Americans are unemployed, some large and small businesses have been closing or filing for bankruptcy in the wake of the Covid-19 crisis, and Congress is deadlocked in negotiations over a new economic relief package designed to help those in economic distress.
Yet, despite the historic economic impact from the Coronavirus pandemic, the stock market has seen a rally that has been as record breaking as the March decline. The Standard & Poors 500 Index (the “S&P 500”), one broad measure of the US equity market, rallied 36% over the 5-month period ending August 31, 2020.
According to LPL Financial Research, this is the best five-month stretch the index has seen in the past 36 years. To quote one of the iconic tunes written by the famous pop/funk legend Prince, the stock market does indeed seem to be “partying like it’s 1999”! The important question that many people are asking is whether this makes any sense.
Artificial Stock Market Rally?
A common opinion I hear is that this spectacular market run up is artificial and unsustainable, and only occurred because of aggressive action taken the US Federal Reserve Bank and passage of the $2.2 trillion CARES Act. Some people even fear that the stock market could go back down to previous levels, perhaps very soon since the US Government may not continue to support the economy on a sustained basis.
I have heard a few prognosticators discuss similarities between the present situation and the year 1999 (which preceded a dramatic market decline from 2000 to 2002). Like 2020, 1999 was a time that the stock market had produced very attractive gains over the preceding decade.
Some of those strong returns, especially in 1998 and 1999, were attributable to rapid appreciation in technology stocks, also like today’s market. Equity market valuations of the S&P 500 Index, as represented by the Price to Earnings Ratio (“PE”), are similar today to levels seen in 1999, a time of exuberance which did not end well. Those high valuations led to a difficult bear market during the following two years.
Was Prince A Successful Investor?
Is it possible to gain investment insight by listening to the lyrics of Prince’s timeless song? The tune, actually written in 1982, was meant as a satire about fears of the Cold War and was encouraging people to just go out and have some fun before the turning of the calendar to a new century.
Perhaps, the stock market has been following Prince’s advice – in this recent instance, investors did not have 18 years “to party” so the market celebrated in just five months! But is the party about to end? Is the current situation a setup for a bear market, just like 1999?
I am very skeptical about such a comparison and the inevitability a bear market in the near term. Before rushing to press the “sell” button, I would urge you to avoid making significant portfolio shifts based on hunches and guesses. This particular narrative sounds good on the surface but does not at all tell the whole story.
History May Explain the Equity Market Rally
My opinion is not based on a naïve belief that stock prices always go up or that the re-emergence of a bear market is impossible. Today’s investors do face risks, and we should not dismiss those risks or any possible scenario. In the short term, there is a distinct possibility of a stock market correction, which may have already started this month. However, the story of stock market irrationality or an imminent crash does not appear to hold up based on market history and the fundamental drivers of stock prices.
In fact, it is quite common for stock prices to rally strongly before the economy completely recovers from a downturn. Stock prices move in response to expectations about the future, which means that it is not unusual for the stock market to rise when investors collectively expect the economy to improve, even while the economy may be currently struggling.
This is what appears to have happened since the end of March and might likely be an important contributor to the recent stock market performance. It is true that the CARES Act, combined with the bold actions taken by The Federal Reserve Bank, have also played an important role in the market rally.
US Economy Shows Rapid Progress
But investors might also be responding to a rapidly improving economy. A broad range of economic data reported over recent months has shown a sharp snapback in activity. In fact, the data is far surpassing the collective forecasts of professional economists whose views are regularly surveyed. A closely followed index for tracking economic surprises (called The Citi Economic Surprise Indexes) remains near record 17-year highs, according to LPL Research.
Some economic forecasters expect US Gross Domestic Product (“GDP” which is the total output of all goods and services) to increase more than 30% in the Third Quarter (although this comes off of a whopping 31.7% decline in the Second Quarter). Notably, the strong economic showing has continued during the summer, even while the US was experiencing a spike in Covid-19 cases.
Another consideration: Certain economic data sets have historically been reliable predictors about the future direction of the economy. Two of the most important “forward looking” indicators closely watched by equity investors are the Institute of Supply Management’s Purchasing Managers Index (“PMIs”) and the Conference Board’s Leading Index of Economic Indicators (“LEI”). These two indicators are also showing that a recovery is underway and may likely continue.
In short, the economy may still be in distress, but significantly less so than five months ago. The majority of the reported data suggests that a continued recovery is likely, although the pace of the comeback may likely slow from what has occurred in recent months.
Predicting The Future May Noy Be Essential
We may not be able to foretell the future speed of a likely economic recovery, how soon a Covid-19 vaccine may emerge and other actions that may help us adapt to and ultimately overcome this very formidable virus. But the trend for the economy seems to be moving in the right direction and does not present an obvious “sell all” signal! Of course, there are risks to a continued recovery, such as another economic shutdown due to a second Covid-19 outbreak, economic policy mistakes by the US or other governments, among other factors. However, it is far from clear that these events are likely to occur.
The likelihood that the equity market may experience a correction is also not unusual and in and of itself, may not be a reliable predictor of the future. Once again, looking at the history of markets is useful.
Equity markets experience corrections of all shapes and sizes during most years, not just during recessionary times. Trying to navigate these movements is extremely tricky and may jeopardize the likelihood of successfully moving to your long-term investment objectives. If you are considering making a “directional” bet with a significant percentage of your portfolio, you should exercise great caution or forget about the idea entirely.
I think both Prince and the pessimists may have it wrong. You don’t have to think that the stock market party will continue forever, nor do you need a crystal ball to predict when the party will end! Sticking to your disciplined investment plan may give you the best chance of successfully moving toward long-term financial goals.
As always, I welcome your questions and comments.
