This seems to be one of the most asked questions in the finance industry in 2020…from clients and professionals alike. While there are nuanced reasons for this seemingly disconnected state of reality, I’ll share the simpler point first: The stock market is a forward-looking machine (often referred to as a leading indicator). On a general basis, the market is looking beyond the pain of the current economic conditions brought on by the virus-related shutdowns and is predicting recovery in the level of earnings. The forward-looking timeframe utilized by market participants shrinks during times of great concern and lengthens during periods of renewed optimism. This was clearly observed during this last period of volatility in early 2020. As news of the virus worsened and economic shutdowns ensued, investors fearfully sold-off risk assets, including equities, indiscriminately and en masse. While the economic pain would certainly have an impact on company earnings in the shorter-term, were these companies worth 30-40% less than they were in February? In most cases, of course not. The forward-looking timeframe utilized by the market shrunk from 12-18 months to several weeks to a couple of months. The opposite holds true when the economy begins to work itself out of a recession, which is where we find ourselves currently. When recovery is signaled, green shoots are spotted, and fear is replaced by hope, the forward-looking timeframe employed by investors stretches back to 12-18 months…and for a period, maybe even further into the future. These changes in investor behavior are explained more by psychological forces than strict adherence to economic theory or fundamental analysis.
To further examine the causes of the market’s record breaking rebound and apparent disconnect from the Main Street economy, our investigation must get more complex. The events of 2020, namely the Coronavirus and widespread economic upheaval caused by the pandemic, has created massive and record-breaking changes in portfolio holdings and fund flows. As investors have tried to properly position themselves to avoid deep losses and conversely profit from companies that stand to gain from what has commonly been referred to as “the new normal”, specific sectors of the market and asset classes have experienced outsized gains. Adding to the frenzy of buying in these favored stocks and asset classes, global economic stimulus has now reached over $30 Trillion or 35% of the world’s GDP. This has provided investors with plenty of liquidity to invest in these preferred areas, consequently sending prices sky-high.
The second and third quarters of 2020 have seen tremendous growth in specific technology stocks and companies that benefit from the “stay at home economy”. Interestingly, technology names often categorized as growth stocks were also seen as defensive positions, as their revenues were not expected to take major shutdown-related losses. For those investors looking for risk, the options for investment seemed to narrow around these themes, pushing the stock price of these companies up, bringing indices along for the ride. Much has been said about the fact that a majority of the growth in markets and the indices that track them is a result of the outperformance of behemoth technology companies, while a substantial portion of companies still trade down for the year. While this is often not viewed in a positive light, it does help explain why market performance as viewed by the S&P, NASDAQ, and Dow Jones may not match the perception of reality in the broader economy. In fact, the sectors that are being impacted deeply by the virus, like Travel and Leisure and Retail, are appropriately lagging the market and reflecting more of the reality we see around us.
It should be noted that this recession and bear market were brought on by a very atypical series of events…as was the fast rebound and recovery. Until this year, shutdowns of entire economies across the globe has never occurred. Nor has the amount of monetary and fiscal stimulus pumped into economies ever been matched. To be specific, the US economy started the year with historically low levels of unemployment, rising wage rates, a strong housing market, and from the view of many, a positive outlook for company earnings in 2020. While a great deal of this fruitful economic activity was brought to a halt by the virus-slowing shutdowns, several key elements driving the economy remained fully intact or were only paused temporarily. For many, their jobs and income levels remained constant…and for others, additional unemployment benefits and one-time stimulus checks kept household finances in the black. With government shutdowns disproportionately impacting small businesses, household and business purchases were directed primarily to large, public companies. This phenomenon contributed to off-the-charts profits for many companies, driving their stock prices higher. Again, we see cause and substantiation for the divergence between observed economic struggles and market performance.
Lastly, the impact of the federal government’s monetary and fiscal policies on risk asset prices cannot be under-estimated. To be clear, the massive amount of stimulus both in the US and across the globe are no-doubt supporting market performance. Excess liquidity often finds itself in risk assets and assuredly this time is no different. Likewise, low interest rates are a tailwind for growth companies, as witnessed by the fact that growth continues to handily outperform value strategies. Coupled with fiscal stimulus measures aimed at supporting businesses and maintaining income levels that buttress consumer spending and stave off defaults, markets are demonstrating confidence.
This author believes that all these elements working together are responsible for the divergence between a struggling economy and solid market performance. While there are opportunities to be had, this past week has clearly shown us that there are also substantial risks in this environment.
These are very challenging times for investors and dramatic and rapid swings in both directions can produce severe consequences. A disciplined approach with a keen eye on fundamentals is more vital than ever.
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