STOCK MARKET ANALYSIS
Even bulls run out of steam… don’t they?
What’s happened, what’s happening and what’s next in the markets.
In this piece, I want to discuss the stock market. The phrase might be tired, but the events of the past year have been unprecedented. We’ve witnessed a remarkable and sustained rally across equity markets, despite the onset of a global pandemic.
Why has this happened? Where do we stand now? Can this continue? — Let’s find out.
Note: obviously, this is not financial advice. All views expressed are simply my opinion.
What’s happened?
In March 2009, the US equity markets were primed for a resurgence after weathering the storm created by the housing crisis — and resurge they did. The post-crisis US bull run lasted more than a decade, marking the longest bull run in history. The below chart illustrates the magnitude of the rally, as well as the significance of the ‘coronavirus correction’ compared to the 2008 crash.
Fast-forward to March 2020, investors started to realise that COVID-19 posed a real threat to the stability of the global economy, leading to the largest stock sell-off in history. The S&P 500 plunged more than 1150 points from its February high to its March low. However, this would prove to be one of the briefest bear markets on record. Despite the unemployment rate sitting at an all-time high, and entire sectors of the economy being ground to a halt, the index sprung into recovery seemingly as quickly as it had fallen.
Enter: an (irrational?) bull market.
Throughout the course of 2020, equity markets across the globe have made remarkable recoveries, none more so than the US — Why?
1) Tech stonks
The pandemic, and requisite lockdown restrictions, have had a disproportionate impact on small businesses. Mass unemployment was felt predominantly in the labour-intensive retail and hospitality sectors (which begs the tangential question: how will the competitive landscape of these industries look post-COVID? We’ll touch on that another day).
Whilst these sectors are essential for the day-to-day function of the economy, they are not so significant for equity markets. For example, the seven largest S&P 500 constituents — accounting for 22% of the index weighting — are tech companies that have largely benefitted as the pandemic accelerated the transition to virtual working and consumers shifted more of their spending online than ever. This has meant that the extreme growth of a handful of stocks has overshadowed the decline of stocks in other sectors, pulling the overall index up.
2) Money printer go Brrrrrrr
In March 2020, the Federal Reserve cut its target interest rate to the range of 0–0.25%. The availability of such cheap borrowing made it possible for businesses to finance their operations at very little cost, pushing valuations higher.
A lower base rate also meant lower bond yields, making bonds a less attractive investment. This acted as a catalyst to push investors away from safe-haven assets and towards equities — investors are also likely to be more accepting of market volatility when the Fed is supporting the economy with aggressive monetary policy. The resulting higher demand for stocks helped to maintain lofty valuations and push the market further upward.
In some sense, the financial markets can be thought of as a mechanism to distribute resources to the most worthy companies. If investors make decisions with less regard for the fundamental value of firms, and instead rely on the backstop provided by the Fed, this efficient allocation breaks down. This creates a problem of moral hazard as investors make bets they otherwise would not have the confidence to make.
3) ‘I can’t wait to go back to normal’
The announcement of a vaccine has given people renewed hope of a return to normality. Investors are hopeful of a speedy post-COVID recovery. Whilst the vaccine may mean we can get back into the pubs sooner, it is not the golden ticket to economic prosperity.
The reality is that the economic scarring left by the pandemic will be evident for decades to come.
- Households may not return to pre-pandemic spending levels for fear of further uncertainty
- Businesses may not have the confidence, or creditworthiness, to make large investments to expand their operations
- Government spending will be severely cut
Many businesses will continue to fail and many others will take their place. Whilst this creative destruction is crucial to ensure the creation of a structurally robust post-pandemic economy, this transitional period will not be quick and it may lead to the depression of equity markets.
Where do we stand now?
In my opinion, we are not on the precipice of financial collapse. In fact, the next decisions of the Fed could pose a greater risk to market stability than the pandemic.
Prolonged low-interest rates are justified in the current climate, however, they cannot persist forever. It is a great challenge for any chairman to gradually raise interest rates during a time of uncertainty without crushing investor confidence — sending the market into a nosedive.
Jerome Powell must ensure that he does not give investors confidence that ultra-low interest rates are here to stay indefinitely. Such a signal would magnify the moral hazard problem created by the Fed’s willingness to prop up the economy at all costs, prompting investors and businesses to make more excessively risky decisions. This would create an even larger mess down the line. Investors’ expectations must be nipped in the bud, before markets rise further, to avoid creating an even larger drop when interest rates inevitably begin to rise again.
Picture the economy slowly rising off the ground aboard a runaway hot air balloon — Jerome may be scared to jump, but the longer he waits the harder the impact will be.
