Five reasons why the stock market keeps rising while the economy is struggling
After the recent S&P 500 stock market crash on March 23rd, 2020, the index is up over 36% at the time of writing on 1 June 2020. A 36% gain in just over two months, during a pandemic? It’s understandable why investors are questioning a rise of such magnitude when world economies continue to struggle.
Why is the stock market rising in the global economy?
April 2020 was one of the best months for the S&P 500 (the US stock market) since the 1950s. The reality is that no-one knows what will happen to the stock market from now on. However, the recent stock market rally isn’t as unusual as you may think, despite economic conditions. Here are five reasons to help explain the recent stock market rises during the coronavirus lockdown.
1. Economic data looks at the past but the market looks to the future
First, and perhaps most significantly, even in normal times, economic data looks at the past and the stock market looks forward. By definition, a recession is looking back at the last two quarters or more. So by the time terrible economic data is released, the market has typically long been pricing it in. From there, it’s really just a question of whether the data was in line with market expectations or not.
2. The market hates uncertainty more than awful news
Second, the market hates uncertainty more than awful news. A few weeks ago we learned that over 20 million jobs were lost by US employees in April. This was the worst month for job losses on record. The very same day the S&P 500 futures gained 1.7%. Why? The market was expecting job losses of nearer to 22 million. So relatively less bad news is giving the stock market a boost. Extraordinary but true!
3. Low bond yields make it harder to avoid investing in shares
Third, bond yields going into the pandemic were already low. We haven’t gone into past recessions or bear markets with bond yields this low. In mid-February, the 10-year Treasury bond yield was 1.6%. In Oct 2007, before the Great Financial Crisis, the 10-year Treasury bond yield was 4.7%. This is the return on 10 year US government bonds.
So when the coronavirus pandemic started, many investors couldn’t see an alternative to shares. On May 12th, the 10-year Treasury bond yield was only 0.7%. With the dividend yield from shares on the S&P 500 at 2%, it’s hard for long-term investors to justify selling shares and reinvesting into bonds. In other words income from shares is higher than income from bonds.
4. The next year of corporate profits doesn’t matter that much
Fourth, even if it takes a year to create a successful vaccine, that’s not very long for the stock market. It is for all of us stuck at home, but in the stock market time, it’s just not that long. A company’s cash flow over the next 12 months is only a small piece of the value of the share. That’s what you’re paying for when buying a share: the company’s future cash flows.
From a historical standpoint, PE ratios (share price to earnings, or profits, ratios) are still high. The forward PE ratio is 20.5x. Over the last 25 years, the average forward PE ratio was over 16x earnings. In either case, the next 12 months of earnings is only worth a fraction of the value of the share (1/20th vs 1/16th).
5. Monetary and fiscal policy measures
Finally, the monetary and fiscal response to the COVID-19 crisis has had a lot to do with the market recovery from recent lows. The cumulative relief packages dwarf what we saw in 2008 and that’s before a proposal the other week which will add US$3 trillion more.
The Federal Reserve has injected a huge amount of liquidity into the market: they’re buying bonds and helping maintain liquidity in the money markets and supporting the flow of commercial paper to businesses. For liquidity – read instantly available cash.
Liquidity is important because it gives investors confidence that they can access credit or trade security. When there’s no liquidity, you may not be able to find a buyer if you’re trying to sell a bond for example. Setting the target range for interest rates near 0% has also supported market confidence.
Is the stock market crash of 2020 behind us?
Have we passed the bottom? Is another correction coming? Should you keep investing during a recession? As things begin to reopen and drugs move through clinical testing, we’re going to find out. In the meantime, don’t be surprised if the market continues to move independently of bad economic news.
As you think about whether this is a good time to invest, try not to get too caught up in short term market fluctuations. The stock market is no place for short-term money, anyway. Instead, try to stay focused on factors you can control. This includes how you invest during a crisis and stress-testing your financial plan to weather the storm. A policy of drip-feeding into the market over a period of months, may well work. Also, consider whether or not to change your attitude to investment risk to either increase or decrease the amount you have invested in shares.*
As ever we are available to talk to you if you need a guiding hand. So do not hesitate to get in touch with us if you are worried about your investments. You know it makes sense.
*The value of investments and the income derived from the may fall as well as rise. You may not get back what you invest. This communication is for general information only and is not intended to be individual advice. You are recommended to seek competent professional advice before taking any action. All statements concerning the tax treatment of products and their benefits are based on our understanding of current tax law and HM Revenue and Customs’ practice. Levels and bases of tax relief are subject to change.