Creative Planning President Peter Mallouk. Creative Planning CEO Peter Mallouk.

Maybe the strategists and economists worried about a disconnect between the economy and the stock market were wrong given Monday’s stock market rally that wiped out the S&P 500’s losses due to the COVID-19 pandemic.

Or maybe they were right, given Tuesday’s stock market drop, which seemed to dampen a more positive outlook for the economy as all U.S. states end lockdowns is at least partially. COVID-19 infections and deaths around the country continue to rise, though at slower rates.

Even before Monday’s stellar stock rally, Peter Mallouk, president of Creative Planning, a $45 billion RIA based in Overland Park, Kansas, said in a virtual market outlook webinar last week that the stock market, a “leading indicator” for the economy, is “exactly where it is supposed to be.” He noted, however, that the market recovery reflected the leadership of the top five stocks whose cumulative market capitalization is greater than that of the bottom 350 stocks in in the index.

The year-to-date price gains of those five biggest stocks — Amazon, Apple, Facebook, Google and Microsoft range from 8% for Google to 36% for Amazon, but Zoom beats them all, more than tripling in price so far this year. The S&P 500, in contrast, is virtually flat, up 1.61 points year-to-date to 3,232 as of the close on Monday, having recovered 45% of its losses from its March low, before falling 0.8% Tuesday to 3,207.

Reached Monday after the market close, Mallouk repeated that the “stock market matches the economy,” though many sectors remain off their highs.

“The market believes we will not end up back in quarantine,” Mallouk said, adding that “there seems to be promising treatments on the horizon and maybe even a vaccine.” If, however, the virus starts spreading again, after the recent protests and other gatherings over recent days, the market “will recalibrate,” Mallouk said.

In the meantime, he recommends that investors who believe the worst is over for the pandemic and want to speculate start buying small-caps, which tend to outperform after a bear market.

The small-cap Russell 2000 index has outperformed the S&P 500 since it hit bottom in March. It has risen 55% from the low it reached on March 18, while the S&P 500 has risen 44% from its March 23 low, but the Russell 200 is still down 7.9% year to date.

“Large- and small-caps will outperform emerging market stocks,” said Patrick Poling, a managing director of the Southern Oak Wealth Group who also participated in the virtual webinar, which was led by Joseph Terranova, chief market strategist at Virtus Investment Partners.

The corporate bond market, like the stock market, has also recovered from lows reached in March, with spreads to Treasurys sharply narrower than they were in March, but its performance differs depending on credit quality. 

The iShares investment-grade corporate bond ETF (LQD) , for example, has gained 5.03% year to date, but its high-yield counterpart (HYG) is still down for the year, though only by 1.68%.

The more popular investment-grade AGG iShares Core U.S. Aggregate bond ETF, which includes Treasurys, government agencies as well as investment grade corporates, has gained 5.21%, while the iShares long-term  20-+ Treasury ETF is up 16.5%.

Much of the rebound in the bond and stock markets is due to the Federal Reserve’s aggressive stimulus policies as well as the $2 trillion-plus emergency aid provided by Congress. 

“The Fed restored liquidity to the market, which opened floodgates for corporate bond issuance,” said David Albrycht, president and chief investment officer of Newfleet Asset Management, who also participated in the webinar.

The Fed cut rates to zero and initiated programs to purchase Treasurys as well as investment-grade and high-yield bonds and bond ETFs and to provide multiple lending facilities to back up  the commercial paper and municipal bond markets as well as lenders to Main Street business borrowers.

Investment-grade bond issuance through May has now “eclipsed” the $1 trillion worth of bonds issued for the whole of 2019, according to Albrycht, who sees opportunities in the bond market based on valuation if the economic recovery continues in the second half.

The distressed bond market is another story.

“We have entered a new distressed cycle,” said George Schultze, founder of Schultze Asset Management, during the webinar. Industries and companies that were in trouble before the pandemic, such as retailers Neiman Marcus and J.C. Penney as well as Hertz have already filed for bankruptcy, and there’s probably more to come, Schultze said.

The unifying themes of bankruptcies so far: “they generally have too much debt,” said Schultze. “COVID made that worse,” but he sees opportunities “going through the rubble. Good companies with temporary bad balance sheets will go through restructurings.”

Albrycht expects more defaults in high-yield munis and cautions investors about debt below investment grade. But he expects demand for muni bonds overall will rise because taxes will be increasing to make up for the revenues lost during the pandemic while state and local governments had to pay for increased government services.

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