April’s Rally – Best Month Since 1987

The total cases of coronavirus had accumulated to ~3.6 million with ~250 thousand deaths worldwide. About 30 million unemployment claims had been filed in the past six weeks in the US alone. Companies had reported lower earnings. US PMI had dropped to 41.5% Wherever you look, the economic data is worrying.

And yet, the market is doing great.

US stocks had the best month since 1987 amidst the economic devastation wrought by COVID-19.

This rally does not seem to be supported by fundamentals. How can the stock market do well when the economy is doing so badly?

Could this be a sucker rally?

Fundamentally Supported by The Fed?

“This rally in equities is clearly not driven by fundamentals — it’s driven by the liquidity support from the Federal Reserve,” said Torsten Slok, chief economist at Deutsche Bank Securities.

From unlimited QE, corporate bonds and junk bonds buying, the Fed has already used all cards to support the economy. Whatever it takes.

Certainly, this had helped companies obtain cheap financing to tide through this difficult period.

So maybe, this rally could be artificially fueled by the seemingly unlimited reserves from the Fed following into the financial markets.

Or maybe it is something else…

Misrepresenting The Market

The S&P 500 has been synonymous with the US market. Whenever we talk about the US market rally, we are actually referring to the S&P 500 index.

So when the S&P 500 does really well, does it mean the US economy is also doing well?

S&P 500 consists of the largest 500 companies in US. Largest companies are comparatively more cash rich and relatively affected less by this economic lockdown.

If we include the Russell 2000 which is an index for the smaller companies, we can see that S&P is doing relatively better with just 12.34% fallen from February’s peak while Russell 2000 had fallen 23.71% from February’s peak.

From February’s peak, S&P 500 had fallen -12.34%, Dow Jones had fallen -17.56% and Russell 2000 had fallen -23.71%

Another factor is the constituents of the S&P 500 index.

The top sector in the S&P 500 is Information Technology, a sector which is doing relatively well compared to other sectors in a lockdown.

The second largest sector in the S&P 500 is health care, another sector that has been doing well in the recent health crisis.

Sector breakdown from us.spindices.com

Maybe that is the reason why the S&P 500 was more resilient during this period and bounced back quicker compared to other indices.

So, even when the S&P 500 is going up, it does not necessarily mean that the rest of the economy is doing well.

Investors’ Expectations

In theory, the stock market is a reflection of the collective expectations of all the investors. Investors are basically forecasting future earnings and pricing the market based on that.

When investors anticipate higher future earnings of a stock, they are willing to bid up the price of a stock and bid down the price of a stock if they anticipate lower future earnings.

Economic data on the other hand is often reported after the event had occurred.

So when the market acts radically different from economic data it might not necessary mean that the market is irrational.

It might just be that the economic data is lagging behind the market. Investors could be forecasting an improving economy even while the economy is still in a slump.

When Predictions Fail

Of course, this does not mean that investors’ predictions will always be right because forecasting the future is a really challenging task.

Whenever new information is presented to the investor, whether in the form of economic data or certain world events happening, investors will incorporate the new information in their forecasting models and update their predictions, which in this context means they will adjust price of the market.

So when new information is better than expected, prices will go up.

If the new information is worse than expected, prices will go down.

When new information is well within expectations, the prices will stay unchanged.

That is a reason why markets tend to be very reactive to news, especially unexpected news .e.g. oil prices tanking, declaration of tariffs, escalating death tolls from COVID etc etc…

Historical Example – Great Financial Crisis

Take Great Recession in the United States for example of how the market movements were leading the economic situation (and economic data).

The technical recession officially started in Dec 2007 and ended in June 2009.

However, the start of the recession was announced only in Dec 2008 a year after the recession had started and the end of the recession was announced in Sep 2010 a year after the recession had ended. If we relied on economic data released from official sources, we would have lagged the economic situation by almost a year.

However, if you look at the market, it already started to decline since Oct 2007, two months before the start of the recession and started rallying in Mar 2009 a few months before the end of the recession.

The economic data lagged behind the actual recession; the Stock market was leading ahead of the actual recession.

Throughout the rally there were still bad economic news reported, e.g. unemployment reached 10.1% in Oct 2009 and non farm payrolls declined 6.8% in Feb 2010. However despite all the doom and gloom, the market continued its steady climb.

The investors had already priced in a recovery before the recession ended. And while the bad economic news were being reported, the investors were actually expected worse hence the bad news did not manage to break the market rally.

Conclusion

People often refer to the stock market as unpredictable or irrational especially when it seems disconnected from the economic situation.

The can be many reasons for the recent market rally: Intervention from central banks, imperfect representation of the market indices or just because markets are forward looking.

Nobody really knows why (even when they claim they know).

The bottom line is that:

  1. It is normal for markets to be disconnected from the economic situation. The market is very complex and many other factors which could affect prices (not just the underlying economy)
  2. Economic data alone is insufficient to predict market movements because economic data is lagging while market movements are forward looking.

Predicting the market is very difficult. Hence, it is not easy to time the market.

Author: Fatty's Finance

Finance is like health. It becomes an issue if it is not well maintained. I want to help you get back in shape!

2 thoughts

  1. Yes agree with the last 3 point, but it is still better to stay vested throughout,, there is studied that staying is better than out of market, It is accumulative over time, And staying will see more gain,, then trying to time the market.

    1. Thank you for your comment. Yes, that is basically the point. Timing the market is very hard. If we do not stay in the market, we would miss out some great rallies and less chance to accumulate over time.

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