Mr. Portnoy selecting Scrabble letters to determine his next trade. Akin to Burton Malkiel’s analogy of having monkeys throw darts at the stock pages of a newspaper.
In a time in which a pandemic surges on unabated and seemingly every piece of economic data that comes out is negative, one might’ve thought, especially in mid-March, that now is not a great time to invest. I certainly thought that then, and now even more so. Yet what we’ve been hearing for several months now is that stocks continue to rally, largely recouping their losses from their YTD-lows, and are now on track to reach their all-time highs. So what’s going on exactly?
Employment Picture
The week of March 21, 2020, saw the first spike in initial unemployment claims - 3.3 million. The following week, March 28, saw that number jump to over 6.8 million. It has since fallen to 1.3 million and appears to be climbing back up again. The last time I set foot in an office was Monday, March 9, and in the week or so that followed, cities and states nationwide began issuing lockdown orders. That’s when you started seeing businesses furloughing and laying off employees, particularly the types of businesses you would expect- dining, travel and leisure.
USAfacts.org / US Dept. of Labor
Later we began seeing the unemployment rate reflect reality:
February - 3.5%
March - 4.4%
April - 14.7%
May - 13.3%
June - 11.1%
July - TBD
USAfacts.org / Bureau of Labor Statistics (BLS)
The Fed
As the pandemic broke out in the United States, particularly in New York and Washington, the realization finally dawned on investors that this was going to be worse than SARS in the early 2000s or swine flu in 2009 - it was not going to be confined to China/Asia- it was spreading all over the world - covid-19 is indeed more contagious and more harmful than the previous two outbreaks. And so stocks fell off a cliff. They lost over 30% of their value. The S&P fell from 3,130 points in early March to 2,237 in a matter of about two weeks- the fastest decline in stock market history.
Such was the decline that the so-called “circuit breakers” at the New York Stock Exchange were tripped three times within the span of a week. Prior to this, they hadn’t been tripped since Dec 1, 2008, at a time when the housing crisis lunged the country into a recession. They’re designed to halt trading if certain benchmark indexes, like the S&P 500, fall or exceed certain thresholds, to prevent panic buying or selling, which sometimes could be caused by glitches or algorithmic trading gone awry.
It was around mid-March during the stock market freefall that the Fed announced they would be decreasing the benchmark federal funds rate by 1% to a range of 0% to 0.25%. This is the rate at which financial institutions are able to borrow from the Fed. These institutions then turn around and lend to other banks and corporations. The theory goes that with rates so low, the money is basically free, which incentivizes market participants to engage in borrowing when they otherwise would not if the rates were higher. This process is known as monetary policy.
But in a time of major uncertainty and the entire economy coming to a standstill, much more was needed to stimulate the economy, so the Fed took additional action. Having learned their lesson during the ‘08 financial crisis - they took too long then to act which made the situation worse - this time around, they took swift and decisive action. They announced a series of programs aimed at large and small businesses as well as households and governments representing $2.3 trillion in economic stimulus. In essence, the Fed acted as a lender of last resort for corporations, municipal governments, and Main Street businesses, allowing them to stay afloat, and their asset purchasing programs kept the bond prices of “fallen angel” companies (former investment-grade entities) from cratering. Had the Fed not stepped in, all hell would have broken loose. The financial system would have frozen and the holdings of investors everywhere would have been decimated.
“Stocks Only Go Up”
The phrase made famous by David Portnoy of Barstool Sports has proven true thus far, to the dismay of more serious investors like Howard Marks.
With the Fed’s assurance that major companies and municipalities would not go bankrupt any time soon, and that the millions of unemployed would be kept afloat with the help of expanded unemployment benefits, the stage was set for a stock market rebound, which is exactly what happened (and I, and many other investors, missed this opportunity completely). Here’s the thing- the stock market is not a reflection of the state of the economy- it is in part a gauge of investor confidence in asset prices. At the end of the day, if there are more sellers than buyers, the stock market goes down, and if there are more buyers than sellers, the stock market goes up.
And with so many market participants searching for yield (10-year US Treasury notes have hovered around 65 basis points for quite some time now), it seems the asset of choice has been US equities. Or has it?
The graph below shows the YTD performance of three benchmark indices: dark blue is the S&P, light blue is the Dow, and pink is the Russell 2000.
Yahoo! Finance
The S&P 500 is a market cap-weighted index. This means that the larger the company, the larger its effect of that company’s stock price on the index’s movements. If you take a list of S&P 500 component companies and sort if by market cap, you’ll see that the first six companies are all tech companies- Apple, Microsoft, Amazon, Alphabet (GOOG and GOOGL), and Facebook. And all of those companies have been on a tear since the pandemic, as the economy and how we socialize shifted from bricks-and-mortar and in-person to e-commerce and online. That is why stocks, from an S&P 500 perspective, is 0.47% YTD.
However, the S&P 500 doesn’t reflect smaller companies. Enter the Russell 2000, an index that tracks small- and mid-cap companies. It’s down 12.04% YTD, which I would argue, is a bit more representative of reality.
So it’s important to remember that the headlines aren’t showing the full picture. Yes, “stocks are up” if the stocks we’re talking about are those represented by the S&P 500. But if you expand the scope of what you’re looking at, you start seeing a bleaker picture.
It’s looking increasingly likely Congress will pass additional fiscal stimulus, although it’s not clear yet whether the amount of the expanded unemployment benefits will change. And as any economics professor will tell you, there’s no such thing as a free lunch. There’s a price associated with all of this stimulus, and part of that price is called inflation. There are reasons why we haven’t seen it yet, from a Consumer Price Index (CPI) perspective, although one could argue we are seeing it in rising asset prices, but as we progress through the pandemic and things eventually normalize, there will be a time when we’ll have to reckon with the debt we’ve racked up. Then it’s a matter of whether you’re positioned appropriately to take advantage of and/or weather the events that follow.