If you heard the events that have taken place in 2020 so far and then learned that the S&P 500 was off just 4% for the year to date, you might be surprised. Indeed, many experts have expressed skepticism at the current rally. However, the move up in stocks is not entirely unsupported by fundamentals.
As much as the economy has been weak, economic stimulus has been rapid and vast. Consumers have received stimulus checks. The unemployed have received larger payments. The Fed has supplied liquidity to the market in spades, and corporations have been able to raise debt. The Paycheck Protection Program (PPP) has provided support to smaller businesses. That all amounts to around 14% of GDP. That’s a big number.
Yes, the economy has hit a major shock, but the size of the response should not be understated. The metric that matters is not so much the unemployment rate, but the net hit to economic activity and large stimulus has done a lot to lessen that impact. The economy has fallen, but stimulus provided a large cushion. The markets have seen that.
Of course, the challenge is that unemployment, despite the initial strong bounce, can take some time to fully rebound. For example, the recovery from 2008 took several years. In contrast, stimulus may be relatively short-lived. Programs may expire soon, as such the markets are closely watching the prospects for the next round of stimulus, which is expected this month.
The market is not the economy. The S&P 500 now has a very large weighting to tech stocks. Many of these companies have, on balance, benefited from COVID-19 to some degree as remote work accelerates usage of technological tools and social distancing increases consumers usage of services from Amazon AMZN to Netflix NFLX.
As such the markets are not ignoring the economic pain, but many of the companies suffering most carry a small weight in the index. At the same time, the winners are a big part of the index. For example, Microsoft MSFT is far larger than the entire energy sector it its market weight. Amazon dwarfs all listed travel and leisure companies.
Of course, this analysis also shows the risks that remain for the remainder of 2020 and beyond. The market’s rally has been partly fueled by stimulus. Hence, should stimulus taper off, the market may fall back, especially if the recovery loses some of its vigor.
Secondly, despite having a good run, the valuations of technology stocks, already richly valued before COVID-19 are now elevated by historical standards. The S&P 500 as a whole trade on a Shiller PE of 29x, and unadjusted PE of 22x, when 15x is the historical average. Yes, arguably low bond yields are arguably pushing up valuations, but this doesn’t leave much margin for error if profitability falters.
So, there are reasons for the recent strong run in financial markets, but it’s a delicate balancing act that may not last.