FAQ: Why is the market going higher with Covid still such a big risk to the economy?
Answer: This is a question that has perplexed many since mid-April. In an attempt to clearly explain, I will give you a short answer and a long answer.
Short answer: The short-term moves of the market are extremely humbling to those who try to predict them. It is impossible and even folly to do so. All of your investment decisions should be based on your age, risk tolerance, and long-term goals. Occasionally, we even suggest long-term valuation may drive allocation decisions (the value of this asset class is very low on a historical basis, so I will hold a larger allocation than usual). They should never be based on your idea of what will likely happen in the future. You, like everyone else who tries to predict the future, will get humbled very quickly. As they say in the Navy seals; “Be humble or get humbled”. I can’t think of a better slogan for investors who try to predict the short-term.
Long-answer: There are many factors that play into market direction, specifically in the short-term, but probably the biggest and most overlooked factor from the average investor is price (or value). There is an adage in investing that the greatest cure for low prices is low prices.
In February and March when the serious health and economic effects of Covid became apparent, the market was caught off guard by its severity and began a steep and aggressive selloff. Selloffs of this speed and magnitude are scary to the most logical and hardened of investors and money managers. Essentially, the downward draft begins to lose all appearance of logic and becomes emotional as risk managers, money managers, and average investors begin to panic and decide getting out before they lose any more money (regardless of valuation) will stop the pain and allow them to sleep at night. Notice the words chosen in the previous sentence, emotional words driving decision making; nothing logical. While investors are looking to sell to stop the pain of watching their account balances dwindle, company share prices border on absurd. An example I used in March to describe the illogical market movement was The Walt Disney Company. This is a brand name we all know that runs a diverse entertainment empire. Obviously, Covid would have a serious impact on their parks, sports business (they own ESPN), and film production business. However, these are all short-term disruptions and their foray into digital entertainment and streaming through their Disney+ service is likely to thrive. The stock traded around $150 in January pre-Covid. During the doldrums of the March selloff, the stock had cratered almost 50% to hit a low of around $79/shr. This begs the question of whether a short-term disruption in a part of this company’s business which is almost certain to thrive again in a post-Covid world justify a 50% cut in the valuation of the company. The assertion is ridiculous, and the price was obviously based on fear and panic…not logic. Five months later DIS trades at $130/shr.
This is one small example of what was obvious throughout the stock market. This is also similar to what has happened during past panics, 1929, 1987, 2008, etc. When prices overcorrect on the downside, no amount of bad news can be worse than the fear that the market projected. In fact, when everyone is expecting bad news, bad news tends not to move markets…. but good news will be completely unexpected and drive things much higher. Just like the saying it is darkest before the dawn, when investors get what they expect, the low prices are already reflecting that, which means the only potential for surprise is on the upside.
Once markets did bottom out in late March the federal reserve and federal government began to step in and provide support to the economy through fiscal and monetary stimulus. This began to grease the gears of an economy that was screeching to a halt. Although the magnitude of the stimulus is not sustainable for the long-term, it is a way to prime the short-term pump of the economy while we figure out next steps in the fight against the virus.
The combination of low stock prices (intense fear already baked in) and federal stimulus created an environment where the market was compelled to move higher….and move higher it did. Most indexes gained back everything they lost to achieve break-even returns on the year by July (a rally of about 50% depending on the index) and the Nasdaq has achieved a 20% year to date gain in this wacky environment.
Now, we stand at a place where valuations, at least for technology, seem irrational on the upside. Large-cap technology continues to climb with almost reckless abandon conjuring shades of a tech bubble in a world still fraught with pandemic risks. Logic has again detached from the market in the short-term.
The only advice I can offer during times like this is be careful of being in a position where your portfolio is aligned with the prevailing sentiment. If everyone thinks the same thing will happen in the future (i.e. the market will fall and stay down for a year or two as happened in March), the opposite is almost certain to happen based purely on valuations. As of today, my fear is the prevailing sentiment that technology can do no wrong. I have had several of our members request we purchase Apple, Facebook, Tesla, Amazon, etc. simply because they have gone up lately and are doing well in a Covid world. This is dangerous thinking. Investments should not be purchased because they have done well in the past and you think the future will bring good things for them. They should be purchased on the merit of their valuation (what am I paying today for future earnings).
Don’t try to predict. Allocate. Adjust your allocation based on your age, risk tolerance, goals, and maybe valuations during times when they become extreme and leave the soothsaying to the fortune tellers and weathermen.