Coronavirus Quick Take – June 16, 2020
June 17, 2020
Welcome to another day of Coronavirus Quick Takes. Today we’ll try to answer a common question about the financial markets: Where do we go from here?
2020 has been a wild year for the financial markets. After hitting all-time highs in mid-February, global stock indexes (as well as many bond categories) went into freefall, finally bottoming on March 23 in a wave of panic selling and forced liquidation that sent the All-Country World Equity Index (ACWI) down –35% from its February high. This decline set the record for the fastest decline into a bear market in history.
The subsequent rebound that started on March 24 was also one of the fastest in history. By June 8, only 11 weeks later, the ACWI had recovered to within 6% of its previous high, an increase of +45% over the period. After having experienced a nauseating fall followed by a spectacular rebound, you can’t blame investors for suffering a bit of vertigo.
Two questions naturally arise after such a strong rebound: 1) Why, in the midst of the deepest recession since the 1930s, did stocks (and many types of fixed income) rise so strongly? and 2) Are they likely to take another big tumble before this is all over? This second question became a bit more pressing after last week’s sudden decline, capped by a nearly –6% tumble on Thursday.
Here’s What Really Matters to Investors
The answer to the first question requires that you understand three important characteristics of publicly traded stocks:
- They anticipate the future, reacting to what investors expect will be the situation 4 to 6 months from today.
- The companies traded in the public markets represent only a portion of the overall economy. (For example, S&P 500 companies’ sales represent about 54% of US GDP but only 17% of total employment.)
- In the long run, the only metric that really matters for stock prices are the earnings of the underlying public companies discounted well into the future.
As a consequence, what is happening right now in the economy is of little concern to stock investors—they care about what will be happening during the final months of 2020. In fact, the stock market is one of the best leading economic indictors we have. Thus, the rapid rise in stock prices over the recent past is telling us that later this year, the economy is likely to look a lot better than today. The economy doesn’t have to be great or even near normal; it just has to be meaningfully improved compared to now.
You may have heard that even with all the government support—extended and enhanced unemployment, PPP loans and other programs—many small businesses are likely to remain in bad shape or disappear entirely during this recession. This is likely true. However, small businesses don’t trade on the stock exchange. Public companies typically have much better staying power and access to capital, so that even with the overall economy and many businesses struggling, companies represented by the public markets could still be doing relatively well.
The profits that Wall Street cares about are not just those in the current quarter, even if it often appears that way. The value of stocks today is a function of the discounted future value of all profits many years into the future. That is why, for example, rapidly growing companies like Google trade at a premium to more stodgy businesses such as General Motors—because their future profits will likely be much larger than they are today. A severe recession, particularly if short, may decimate corporate profits for a quarter or two, but have little or no impact on profits over subsequent years. Thus, the intrinsic value of their common stock should not be severely impaired by the recession and the price should rebound once the bad quarters are moving toward the rear-view mirror.
Not Your Parent’s Recession
Investors’ sudden realization in February that the economy was likely to contract sharply owing to mandated business shutdowns triggered the initial decline, which accelerated as emotions took hold in the face of little hard data. Once the panic selling had run its course, the markets realized that companies and workers would receive rapid and robust support from both the federal government and the Federal Reserve, cushioning the blow from the coronavirus recession to both the economy and profits. Subsequently, it became clear that the economy was reopening more quickly than originally expected and that, even with COVID-19 cases climbing in many areas, a recurrence of the March/April statewide lockdowns was unlikely. Thus, on balance, the market rebound was justified, just as the initial sharp fall was supported by the evidence available at the time.
But could new evidence, perhaps of a rebound in COVID-19 cases in the fall or a “double-dip” recession, cause the markets to fall again? This is a reasonable question, especially since most bear markets, including those during 2000–2002 and 2007–2009, feature a “retest” of the initial panic lows. While retests of initial lows are common in bear markets, double-dip recessions are very rare (the only one in the last century happened in 1980 and 1982). Instead, what appears to cause a retest of the initial market low during most bear markets is that recessions evolve more slowly than originally anticipated, with the economic damage becoming more widespread over time.
But this is no ordinary recession, as it is the only one in history created by government fiat to combat an invisible—but deadly—foe. For this reason, many of the traditional rules don’t apply. While periodic volatility and market declines—such as we saw beginning last week—will likely occur between now and the market’s eventual full recovery, we believe these declines will not take us anywhere near the March lows. This is because, even though the coronavirus continues to spread in many places, once economies start reopening, it tends to be a one-way street. Even a major second wave in the fall is unlikely to result in the kinds of widespread lockdowns we saw in March and April. More likely, we’ll see geographically limited rollbacks of some types of business activity, which will slow but not derail the recovery.
Obviously, the future is ultimately unknowable and something else related to the virus or from a completely unexpected source could shock the economy and send the markets reeling again. But this is not our base case and we consider this a low-probability occurrence. For this reason, we continue to encourage our clients to stay invested in an allocation that makes sense for their personal situation and accept the inevitable potholes on the road to recovery.
We’ll continue to write Coronavirus Quick Takes periodically during the pandemic. Please feel free to comment and ask any questions that come up.
The KCS Investment Team
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