There is no doubt that we are living in unprecedented times. Since early March, we have seen about 40 million people, or 25% of the U.S. labor force, file for unemployment, comparable to the Great Depression. On April 20th, U.S. oil prices briefly fell to $ -37.62 a barrel, something many investors did not even know was possible. On April 29th, the U.S. Bureau of Economic Analysis (BEA) reported that U.S. Q1 GDP contracted by 4.8%, the largest drop since the Global Financial Crisis. We can only imagine what the economic data will look like for Q2.
Yet, after falling 35% from peak to trough in just a few weeks from Feb 18th to March 23rd, the S&P 500 delivered its best monthly performance since 1987 in April and continued to rebound in May, making up most of the YTD losses. A strong recovery also occurred in U.S. bond markets.
Many investors are thinking to themselves, why is the stock market rallying despite poor economic data? Here are our perspectives:
- The Feb-March sell-off has a lot to do with the “flight to safety” and forced liquidity from both fund managers and investors. Simply put, there were not enough buyers or market dealers to absorb the volume of sales in the market, driving prices down very rapidly. This over-correction is common when there is high market uncertainty.
- With responsive, massive monetary and fiscal policy support, the liquidity crunch in the financial markets was over in April. The financial market quickly stabilized the supply/demand and closed the under-pricing gap in the higher quality segments of the investment universe.
- Not all the sectors in the S&P 500 suffered from the Pandemic. Winners of this bear market are technology, health care, and consumer discretionary, particularly the mega-cap growth stocks like Microsoft, Apple, Amazon, Google, and Facebook. These companies all benefited from many people sheltering at home, spending time on social media, and ordering goods online. They also represent roughly 20% of the S&P 500 index.
- Most importantly, market prices are dynamic and forward-looking while economic data is backward-looking. The prices that we are observing now have already incorporated the aggregate expectations for the impact that coronavirus developments might have on companies’ future profits. This doesn’t mean that market pricing is always right in the short term, but it does mean that only when the news is worse than what’s already expected will there be a negative impact on the market. At this point, the market expects that the economy will hit the bottom in Q2, then have a smooth U-shaped recovery that takes several quarters to be back to normal, which would make this one the sharpest but shortest economic recession. Whether these expectations and price levels persist will depend on the containment of the virus and a successful re-opening of the economy.
During this turbulent time, it is tempting for investors to stay out of the market and wait until the “smoke is clear” to get back in. However, it’s a fallacy to think that we can profitably jump back in “when the time is right.” Market rallies can occur quickly and generally come in the midst of significant market downturns. You want to be properly positioned to capture the returns when they show up. This recent period of market free falling, followed by a strong rebound shortly thereafter, provides a great example.
Investors don’t need the added stress of trying to figure out where the market is going in the short term in order to have a positive investment experience. What’s important is to have a long-term financial plan and align your portfolio with your risk tolerance and capacity. With sufficient diversification and downside protection built-in, investors will find it easier to stay the course in the midst of short-term turmoil and benefit from the long-term reward of the capital market.