Riding on a high: why is the market hitting records in a recession?

The US National Bureau of Economic Research (NBER), the official tracker of the US business cycle, declared that the recession in the country started in February 2020. According to NBER February was the peak of the business cycle as jobs already started disappearing (even though the huge COVID-driven unemployment claim spikes didn’t happen until mid-March). Over the next month and a half over 42 million Americans found themselves out of work. The official unemployment rate shot up to 14.7% in April (it was 3.5% in February), and has declined back to 10.2% in July, as a more encouraging sign of a recovery driven by business re-openings.

Due to the effects of COVID-19 the uncertainty in the economy is still huge, and is still the biggest it has ever been according to the Economic Policy Uncertainty Index. Almost every graph we see during the pandemic has a label “unprecedented” attached to it; we are usually looking at a very steep exponential curve facing up (for unemployment, uncertainty, or fear), or down (for business and consumer confidence, or future expectations). Oraclum's Fear Reaction Index (FRIX) is also showing a huge spike in negative expectations of businesses and consumers across Europe and the US. People are changing their behavioral patterns and in some cases still voluntarily limiting their mobility and hence their spending (less traveling, working from home, lower exposure to live events, spending less time in restaurants, etc.) while at the same time many are finding themselves in a situation where their jobs are unsafe, which is forcing them to cut down all non-essential spending (like taking loans to buy a car, go on holiday, or refurbish their flat) to brace for an uncertain future. 

In the figure below we can see that mobility in the United States (measured by Google's Mobility Reports, or in other words your phone tracking where you're going) is still not back to its pre-pandemic levels. It is between 20 to 40% lower for transit stations, retail & recreation, and workplaces, and 50% lower for restaurants (on average across the country). The trends are slowly rebounding but with mobility still limited, and with many people in high-paying jobs still working from home and reducing their spending - the upper panel is depicting credit card spending by income group - expect aggregate demand to remain sluggish in the following months. 

Credit/debit card spending, mobility data and restaurant reservations in the United States (data sources: Opportunity Insights Economic Tracker, OpenTable, Google Moblity)

Simultaneously, during this “era of unprecedented events” and sluggish aggregate demand, the stock market is almost completely deaf to all the real economy uncertainty. It did react by the end of February and early March (forward-looking), when it lost 34% of its value from its February 20th peak. This decline lasted for about a month, after which on March 23rd it started bouncing back. And it bounced back astonishingly: the S&P500 saw the best 50-day upsurge in its history, up 52.5% from its trough. 

S&P500 Year to date performance. Source: TradingView

Just as the majority of the population across the US and Europe were starting to adapt to a life in the quarantine — which at the time no one had an idea of how long it might last — the market started growing robustly and two and a half months later it completely reverted the entire February/March decline. It is now net positive for 2020. All this amidst extremely negative expectations from both consumers and businesses of the months to come, where many jobs will be lost and annual GDP is projected to go down around 8% (in the US). In addition to all of this, the US was engulfed in Black Lives Matter protests around the country, and is facing more uncertainty due to the upcoming Presidential election in November. 

How can this be? Why is there such a stark divide between the real economy which is struggling and is expecting a very turbulent second half of 2020, and Wall Street which is riding on a high? Is the market extremely overvalued or is it on point as it correctly factored in the initial uncertainty regarding the pandemic already in February/March and is now simply looking forward to a very fast (V-shaped) recovery?

There are three major explanations:

1. The market is riding on a huge monetary and fiscal stimulus
2. Future expectations of a quick post-COVID recovery
3. Asymmetric effect between publicly-traded companies and SMEs

Let’s examine each of these:

1) Riding the stimuli

It is no coincidence that the market started rebounding just as Congress passed the $2 trillion stimulus package in March, the biggest in US history, a lot of which was oriented towards bailing out big companies like the airlines. Even more important than the fiscal stimulus was the monetary one enacted by the Fed, which decided to once again slash its federal funds rate down to 0.05% in April, opening up room to a $6 trillion injection into the economy through credit and lending programs. This is much bigger than the stimuli and bailout packages administered back in 2008 and 2009.

Low interest rates allow companies to borrow money at low costs which typically fuels a stock market boom. Investors in that case do not want to buy bonds which will give them low yields, but are instead opting for stocks. Even in a situation where the future is highly uncertain an investment in equities offers a better return than an investment into bonds or currencies. And the Fed is giving a powerful signal that the rates will remain low for as long as it takes which to an average investor is a clear sign to buy equities.

2) Exuberant future expectations

Stock markets are all about forecasts. Collective forecasts of all investors looking 6 to 12 months ahead. When it’s going up it is because investors, the majority at least, are collectively expecting the economy to bounce back quickly and adapt to the pitfalls of the pandemic (the quarantine, restricted mobility, etc.). While the initial bounce-back was entirely driven by the Fed and the federal government, the continued rise of the markets from May to August was down to optimistic forward-looking expectations: firms will successfully adapt to the pandemic, the reopening will see things return to normal rather quickly, and a vaccine will be found sooner than expected. Typical investor optimism, perfectly encapsulated by the CNN Money's Fear & Greed Index signaling that the market is currently in the green "Greed zone". 

The Index looks at junk bond demand, the volume spread in put and call options, momentum, volatility, etc. Source: CNN Money

When such expectations become prevalent among the majority of investors the markets very easily enter a frenzy and a lot of investors starts buying in, worried that they will miss out on the great opportunity. It doesn’t matter if their expectations are unrealistic, if they're buying stocks of companies that have filed for or are on the verge of bankruptcy, or if their expectations are based on miscalculations over the impeding threat of the virus and an inability to understand fat-tailed distributions of things like pandemics. As long as everyone is buying, time is ripe to enter the market. This logic has time and time again been proven wrong and has very often ended with a negative effect on investors’ finances. At least for the small investors.

WHO data on daily COVID-19 cases across 6 regions

3) The firms driving the markets vs the firms that are shutting down and laying off

Which firms in the US have disproportionately represented the growth in the stock market over the past decade? Big tech companies. Five tech stocks account for 20% of the overall market value of the S&P500: Apple, Amazon, Alphabet (Google), Microsoft and Facebook, all of which, except for Facebook, have passed the $1tn valuation (and Apple passing a $2tn valuation last week). These companies that have seen a huge rebound in market value over the past few months (see graph below) as investors see them as the big winners of the pandemic where more and more things will be switching online. Even the smaller tech stocks of companies like Zoom or Netflix were reaping huge rewards from people staying at home and using more of their services.

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

Although not all tech companies have experienced an upsurge in sales, the markets are all about expectations, and expectations are that things are moving online faster than ever. This is the “new normal”. It is thus no wonder that tech companies’ stocks are benefiting from an upsurge in demand for online services.

On the other hand, companies laying people off have mostly been micro, small and medium-sized businesses who were hit hardest by the pandemic as they had to close shop during the lockdown. This is where the unemployment spike happened but since none of these companies are listed on the stock market their relative performance is not factored in. Not yet at least.

Other companies that were laying people off were airlines and the hospitality industry, but in their case the major players have been bailed out by the government while their stock prices have been moving up in recent weeks. This is a powerful sign of irrational exuberance; many of these companies have had cash flow problems even before the pandemic, and are now piling up a lot of debt which should hurt their future prospects and send their prices down, not up. Airlines are in for a very rough couple of years. It should be the last thing on an investor’s list to buy right now.

Is the market right and what happens next?

The forward-looking expectations on the stock markets right now which are driving indices up are disregarding several factors that are contributing to a bleak outlook of the economy.

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.

Finally, I'll leave you with a quote attributed to Keynes: "The market can remain irrational longer than you can remain solvent."

The first version of this article was published on Seeking Alpha. This is the updated version.