After the recent low point for the S&P 500 on March 23rd, 2020, the index is up over 28% on a total return basis as of May 12th. A 28% gain in less than two months, during a pandemic? It’s understandable investors are wondering why there’s such a disconnect between the stock market and the economy.
Why is the stock market rallying in this economy?
April 2020 was one of the best months for the S&P 500 since the 1950s. In truth, no one knows what will happen in the stock market from here. But the recent stock market rally isn’t as strange as you may think, despite economic conditions. Here are five reasons to help explain recent stock market gains during the coronavirus pandemic.
Economic data looks back, but the market looks forward
First, and perhaps most significantly: even in normal times, economic data looks back and the stock market looks ahead. By definition, a recession is looking back to the last six months or more. So by the time devastating economic data is released, the market has typically long been pricing it in. From there, it’s essentially just a question of whether the data was aligned with market expectations or not.
The market hates uncertainty more than bad news
Second, the market hates uncertainty more than bad news. On Friday, we learned over 20 million jobs were lost by U.S. workers in April. This was the worst month for job losses on record. S&P 500 futures gained and closed the day up 1.7%. Why? The market was expecting job losses around 22 million.
Low bond yields make it harder to turn away from stocks
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 yield was 1.6%. In Oct 2007, before the Great Financial Crisis, the 10-year treasury yield was 4.7%.
So when coronavirus hit, many investors didn’t see an alternative to stocks. On May 12th, the 10-year treasury yield was only .70%. With the dividend yield on the S&P 500 at 2%, it’s hard for long-term investors to justify reallocating stocks to bonds.
How do interest rates affect bond yields?
The next year of corporate earnings doesn’t matter that much
Forth, even if it takes a year to get a vaccine out, that’s not terribly long for the stock market. It is for all of us stuck at home, but in stock market time, it’s just not that long. A company’s cash flows over the next 12 months is only a small piece of the value of the stock. And that’s what you’re paying for when buying a stock: the company’s future cash flows.
From a historical standpoint, P/E ratios (price to earnings) are still high. The forward P/E ratio is 20.5x. Over the last 25 years, the average forward P/E ratio was over 16x earnings. In either case, the next 12 months of earnings is only worth a fraction of the value of the stock (1/20th vs 1/16th).
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 this week which would add $3 trillion more.
The Federal Reserve has injected a tremendous amount of liquidity in the market: they’re buying bonds and helping maintain liquidity in the money markets and supporting the flow of commercial paper to businesses.
Liquidity is important because it gives investors confidence that they can access credit or trade a 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 is 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. But in the interim, 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 dollars, anyways. 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.