Riding on a high: why is the market hitting records in a recession?
|Credit/debit card spending, mobility data and restaurant reservations in the United States (data sources: Opportunity Insights Economic Tracker, OpenTable, Google Moblity)|
|S&P500 Year to date performance. Source: TradingView|
There are three major explanations:
- The market is riding on a huge monetary and fiscal stimulus
- Future expectations of a quick post-COVID recovery
- Asymmetric effect between publicly-traded companies and SMEs
1) Riding the stimuli
2) Exuberant future expectations
|The Index looks at junk bond demand, the volume spread in put and call options, momentum, volatility, etc. Source: CNN Money|
|WHO data on daily COVID-19 cases across 6 regions|
|Comparison of stock performance of the top 5 tech companies in the S&P. Since December 2019 Amazon grew by 48%, Apple by 27%, Microsoft by 25%, Facebook by 18%, and Google by 8%. Source: barchart|
Is the market right and what happens next?
First, aggregate demand is very likely to keep stagnating or decreasing. The effects of the pandemic are going to be felt in months, even years to come. Many companies that survived the initial blow might not do so in the coming months which will further decrease confidence and depress demand. People are changing their spending behavior and are postponing all major nonessential purchases. High-income individuals are lowering their mobility (less travel, working from home) and are hence spending less (see first figure above, upper panel), while lower-income individuals are afraid of losing their jobs which is increasing their uncertainty and reducing their aggregate spending.
It is a matter of time before this depressed demand spreads through the economy and by then it will impact even the tech stocks’ performance (although certainly to a much lesser extent than other industries).
All the major macro fundamentals are pointing to a bleak outlook. The second quarter US GDP is down 32.9%. The Atlanta Fed, which uses real-time GDP estimates based on available data, is however estimating a 25.6% rebound in Q3 (August 17th estimate), which is still not high enough to offset the negative growth in Q2 and Q1. For Q2 their estimate was a negative 34.7%, so very close to the actual numbers. This suggests that firms will keep suffering with bankruptcies increasing, meaning that upon finally realizing the extent of the shock the market could be in for a sobering autumn/winter season.
Comparing the trend of this recovery to trends of previous recoveries is pointless. This was not a typical economic crisis and the reaction of the economy to the pandemic was completely asymmetric. During the previous 2008-2009 recession the contagion spread from the financial sector into the real economy. Today the reverse is highly likely, particularly with respect to the corporate debt market. Furthermore, no simple approximation of previous trends can tell us anything about where the markets might end up by the end of 2020. It is therefore crucial to keep listening at the social sentiment of people and tracking the fundamentals of companies – such as their cash flow and exposure to debt – in order to make an accurate market valuation.
Second, the government’s stimulus will run out as it will soon have to start worrying about rising debts and deficits. During the heyday of the pandemic the measures have been implemented with a clear indication that we will deal with debts and deficits later, once the economy is saved. This “later” is coming sooner than expected and is seriously undermining all expectations of a V-shaped recovery. During the previous crisis the aftermath of rising debts almost destroyed the euro as several European economies were on the brink of bankruptcy. Most of them still haven’t recovered from that sovereign debt crisis and will soon be engulfed in another one. This unfortunately signals more uncertainty and instability and calls for further monetary easing on both sides of the Atlantic, further fueling the monetary bubble.
Third, the virus is still spreading globally as it is hitting South America, Africa and South East Asia, and is on record highs in the United States. It is obviously impossible to predict whether there will indeed be a large second wave but not many companies are prepared in case it does happen. In other words, we are collectively still exposed to another big shock and do not have any hedging instrument or insurance policy as protection. We cannot know for sure whether it will happen but we can take measures to benefit from the shock. Hardly anyone is doing this.
How should investors position themselves in light of these trends? A good hedging strategy is crucial. Set aside a fraction of your portfolio into put options on the S&P (or selected stocks that are likely to be hurt the most in case of another crash - look for over-leveraged companies with cash flow problems caused by the pandemic). A put option delivers a limited loss if the implosion never happens (the put simply expires and you lose the amount you paid for the option). But if it does happen the put is activated and the investor gains a convex payoff benefiting from the market decline.
Taking all this into account we can cautiously claim that the market is not right. It is being driven by exuberance which will end soon. No one can predict when this will happen which is why it is a good idea to already start building a strategy of how to benefit from another potential downturn. Even if it never happens.