The Second Quarter of 2020 was marked by a glaring contradiction, one of the strongest equity rallies in the last fifty years against likely the greatest decline in GDP in the U.S. (and globally) since the depths of the Great Depression of the 1930s. As we have noted before, economic data and markets don’t necessarily move together; economic data tends to be backward-looking while markets are forward-looking.
Every metric of economic prosperity, from employment to corporate earnings, to individual, corporate and government debt levels, to international trade are estimated to remain below year-end 2019 levels through 2021. So while conventional wisdom is that the market looks out six months, if you believe the market is following the fundamentals, today's market is looking out much further.
What is driving current market performance?
One argument is that the market is responding positively to improving prospects in the fight against COVID-19. However, recent upticks in infection rates, coupled with a reasonably high likelihood of even higher infection rates come fall, call this argument into question.
Another possibility is that the economy is recovering. After the steep decline in economic activity in the second quarter, even modest increases in activity will look significant on a percentage basis. While the data shows the economy is recovering, we can’t hope to reach 2019-levels of economic activity until the last frightened consumer’s spending returns to normal, and the last frightened CEO restarts their corporate investing.
So where is the support in equity markets coming from? We argue the Federal Reserve.
Interest Rates and Money Supply Are Supporting Equities
Interest rates for short-term loans have functionally been at 0% since March and longer-term loans to the government (Treasury), are functionally at negative real rates if you assume a 2% inflation rate over the holding period. Who wants to loan the government money only to get back the same amount or less? By making bonds less attractive the Fed has pushed investors into riskier assets, like stocks, to get the same level of return they used to get from safe bonds.
More importantly, the printing presses are running at full steam and the money supply has exploded since March. That money is sitting in banks, in the form of demand deposits, but it can be used to finance and collateralize loans to buy other financial assets. That cushion of cash is supporting equity markets in a way that we haven’t seen before.
Putting this all together, we come up with a familiar conclusion–don’t try to predict the market–but for different reasons. The market isn’t moving because of the news you see on TV or read online; even if you could predict that news, you wouldn’t necessarily be able to predict the markets. For the time being, the market seems to be dominated more by the Federal Reserve and its actions than any specific narrative about growth or earnings.
Trying to predict the Fed’s action has a long history, but in this case, the Fed has broadcast their intentions: to keep money flowing freely for at least the next 12 to 24 months. Does that mean the market will keep climbing the ladder of cash the Fed is building? Maybe. But maybe not.
Your Goals, Risk Tolerance and Timeline Should Drive Your Strategy
Ultimately, strategies that monetize the economy, e.g., flood it with cash, could eventually lead to distrust of the Fed, or inflation, or both. ; The challenge is not just predicting the Fed’s action, but predicting how the market will digest those actions over time. The compound nature of the predictions you need to get right to effectively time the market is the primary reason that virtually no investor, even the most sophisticated professional, has been able to make money by persistently timing the market.
It’s hard to feel optimistic about markets given the long road to recovery ahead and the relatively high valuations we see now, but that’s not a sufficient reason to change your long-term equity allocations. While both the economy and the coronavirus are systems (one social and one organic) that follow certain patterns of rules and logic, markets are different.
Markets have infinite feedback loops that no super algorithm can crack. Unlike other systems, once it is cracked, the market will change, rendering the approach useless. In other words, even if you outsmart the market, the market will come back and outsmart you. So even when it is difficult, staying the course is the most logical thing to do.
