Dazed and confused.
That’s probably how you are feeling right now as you watch the stock market rally while we continue to see some of the worst economic data since the Great Depression. On the surface, it would seem like a massive disconnect. We know things are bad, so why isn’t the market behaving as such? Because we knew it would be awful.
The economic numbers are abysmal, but we barely bat an eye as the data is released because we are simply not surprised at the economic toll this crisis has created. In some respects, things are thankfully not as bad as we feared. In fact, some developments have left us feeling more and more optimistic as each day passes.
Markets move in relation to expectations, not actual outcomes. Hence the reason why the market dropped precipitously as the COVID-19 crisis first played out – absent clear information in a crisis, our imaginations run wild and we begin to “expect” much worse outcomes than what is logically or probabilistically reasonable. You can thank biology for that. Great for keeping you alive. Potentially detrimental to your investment portfolio.
Markets move in relation to expectations, not actual outcomes.
So, the key point here is that markets move on what we call second order effects. Meaning, it’s not the actual outcome that matters (the primary effect), it’s how the actual outcome compares to the average expectation at that point in time. In the context of our current state of affairs: Things are bad. However, things are LESS BAD than expected, and that's what drives the stock market in the short-term.
In the context of our current state of affairs: Things are bad. However, things are LESS BAD than expected, and that’s what drives the stock market in the short-term.
Where we go from here is still anyone’s guess. Don’t be fooled that we can truly have the foresight to know how the rest of the pandemic plays out; and perhaps more importantly, what the intermediate and longer-term ramifications will look like. At this juncture, the stock and bond markets are relieved that we received an unprecedented monetary and fiscal stimulus that is helping us bridge this extremely desperate situation (Stimulus = HUGE backstop). However, it doesn’t rule out the fact that businesses will go into distress during and after the initial wave of this crisis, perhaps ceasing to exist and taking the jobs it used to fill with them, forever. Uncertainty is very high, so we must continue to be cautious.
Remember, just as the market moves upward when things move from bad to “less bad,” the market can also go back down if our sentiment gets “too rosy” and the new data serve to remind us that, yes, things are still bad. Or, potentially, getting worse again.
That’s not to turn this situation completely negative – there are still ways to benefit even if we go into a period where the market oscillates from positive to negative sentiment in coming months, as we deal with the fits and starts of getting out of this crisis.
One thing to remember is that the composition of our economy is always changing (economic theory calls this creative destruction). Some businesses were on their way out anyways (sorry JC Penney and much of traditional retail) and this crisis may have just accelerated their demise (or at least a restructuring under bankruptcy). On the other hand, there are some businesses that are challenged right now but will likely have an important role in society and the overall economy as things return, at least somewhat, to normal (travel, leisure, dining out, etc.). Furthermore, innovation will create new winners through businesses that succeed in a post-COVID-19 world (such as e-commerce, contactless payment, specific medical technologies, etc.). While we don’t know exactly how the chips will fall, we can evaluate business opportunities and make savvy investments where the expected reward compensates for the risk taken – we don’t just have to “own” the market.
While we don't know exactly how the chips will fall, we can evaluate business opportunities and make savvy investments where the expected reward compensates for the risk taken - we don't just have to "own" the market.
Lastly, we would be remiss if we didn’t point out the fact that “what we see is not necessarily reality.” Take the most frequently referenced stock index for example: the S&P 500. While the S&P 500 displayed a strong rally off the March 23rd low (39%+), it is only down in the single-digits from the beginning of the year as of the date of this writing. Contrast that, however, with the “average stock” in the index (the equal-weighted index as a proxy), which is down in the mid-teens from the beginning of the year. Furthermore, because the S&P 500 comprises the largest businesses in the US, this misses the performance experienced by the smaller, closely-held businesses (think about many of the local restaurants and small retailers that are most heavily impacted right now).
This tells us that the “market” performance (as measured by the S&P 500) is being skewed upwards mostly by a handful of large-cap, growth-oriented stocks that have been either mildly impacted, or even enriched, by the current crisis. These are good businesses, perhaps, but not reflective of what most businesses are experiencing or expect to be experiencing going forward.
What all this means is that we are not letting our guard down. This is where our diligence and conservative style of investment selection will work in our favor and help continue to preserve our clients’ wealth while setting them up for successful growth going forward.
We are here to be your guide and welcome all phone calls and emails. Please continue to stay healthy and safe and remember that better days lie ahead.
Norris, Perné & French, LLP