Equities rallied dramatically in April, continuing the recovery that started in late March. The S&P 500 Index gained more than 12% for the month, rebounding more than 30% from its March lows. Non-U.S. equities also rebounded.
The stock market rally may seem inconsistent with the economic reality of skyrocketing unemployment and collapsing GDP growth. However, the divergence between economic indicators and stock market performance is not unusual. Stock prices are forward-looking indicators and often rise in advance of an economic recovery. Powerful policy actions by the Federal Reserve and fiscal assistance provided by the Coronavirus Aid, Relief and Economic Security (CARES) Act played in important role in stabilizing investor expectations. Government and central bank support reduces the near-term risk that liquidity challenges will create a wave of personal bankruptcies and business failures. Optimism about progress in slowing the pace of COVID-19 infections and the mobilization of efforts to identify therapeutic treatments also boosted investor sentiment.
Despite the recovery from the market’s March lows, investors should remain cautious about the near-term outlook for equities. Being “allowed” to go to stores, restaurants and airports is an important start, but many people will hesitate to do so until the health risks have been reduced. Economic activity should pick up with a gradual easing of social distancing measures, but many businesses will reopen at less than full capacity. Consequently, the rebound in employment and economic activity may be slower than hoped, and the bleak economic indicators reported in March and April are likely to get worse before getting better.
With a vaccine likely to be a year or more away, progress in containing the COVID-19 pandemic is a necessary condition for the stock market rally to continue. Without widespread and reliable testing, rapid contact tracing, and effective treatment capabilities, it will be difficult to resume activities previously taken for granted. A careful return of social interaction, progress in testing for COVID-19, isolating and treating the sick, and contact tracing would be a recipe for markets to rise during the rest of the year.
There are a variety of risks to be monitored. A second wave of infections is possible as social distancing requirements are loosened. The CARES Act offsets some of the economic damage caused by the economic “lockdown” resulting from the first wave of infections, but would be insufficient if another shutdown becomes necessary in the fall. Election-year politics may make additional fiscal support harder to negotiate, magnifying the market risk if the pandemic isn’t contained. Tensions between the U.S. and China are rising as a consequence of the pandemic, jeopardizing last year’s truce in the trade war.
Although the Federal Reserve and U.S. Congress have provided policy support to help offset some of the economic damage caused by COVID-19, some governments are falling short of what is needed to combat the economic damage caused by the pandemic. Spain, Italy and France are among the countries that may need to do more to support their ailing economies. The flawed structure of the euro area — which has monetary union without fiscal union — creates political complexity that makes it difficult to respond with the necessary speed to an economic crisis. Throughout the world, the longer that social distancing lasts, the greater the likelihood that “temporary” job losses become permanent.
Of the wide variety of possible future events, two extreme scenarios are possible: a severe bear market in equities that lasts longer than currently forecasted or a rapid recovery in equities that leads the markets to new highs. Although the most likely outcome lies somewhere between the two extremes, in positioning portfolios investors should consider striking a balance between the risk of losing money and the risk of missing opportunity.
The economy seemingly shifted overnight from expansion to recession. In these uncertain times, it may be appropriate to prioritize liquidity and capital preservation over investment options that offer the highest but most uncertain potential returns. Quality-focused investments — companies with strong business models, balance sheets that can hold up under stress, and the ability to rebound in what is likely to be a very different world when the pandemic ends — may be safer options for this challenging environment. There may be significant performance dispersion between high quality companies and weaker, higher leveraged, less profitable companies during and after the recovery.
It is important to avoid overreacting to the latest headlines, as the coming weeks (and months) are likely to be an emotional rollercoaster. In that spirit, Artisan Partners portfolio manager Dan O’Keefe has a timely reminder: “The value of a business is the present value of all future cash flows, not just those over the next few months.” Things may get worse before they get better, but dislocations like the pandemic have often been buying opportunities.
— Related on ThinkAdvisor:
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Daniel S. Kern is chief investment officer of TFC Financial Management, an independent, fee-only financial advisory firm based in Boston.
Prior to joining TFC, Daniel was president and CIO of Advisor Partners. Previously, Daniel was managing director and portfolio manager for Charles Schwab Investment Management, managing asset allocation funds and serving as CFO of the Laudus Funds.
Daniel is a graduate of Brandeis University and earned his MBA in finance from the University of California, Berkeley. He is a CFA charterholder and a former president of the CFA Society of San Francisco. He also sits on the Board of Trustees for the Green Century Funds.