During the depths of the first quarter market plunge, we discussed our view and expectation that the stock market would rebound well before the economy improved or the COVID-19 virus was contained. History has taught us that equity markets don’t wait for all the bad news, economic fallout and corporate earnings decline to end before moving forward and looking into the future. This time was no different. The S&P 500 Index bottomed on March 23rd, a day when the cumulative global COVID-19 case count totaled less than 380,000. Today we are closing in on nine million cases worldwide, corporate earnings are expected to decline by more than 40% this quarter and we are currently experiencing one of the largest economic contractions in history. However, the S&P has rocketed higher over the past three months, up roughly 40% from those March lows and within sight of all-time highs. While the disconnect between the current gloomy state of the economy and the extraordinary equity market rally is apparent, it’s also not dissimilar to how previous market recoveries have unfolded.
As the second quarter progresses, we see the broad-based improvements that the market started to sniff out months ago. Not surprisingly, the start of the economic bottoming process has aligned very well with the reopening of the U.S. and global economy. Weekly unemployment claims have steadily declined since the late March peak. Consumer spending is recovering far quicker than most had expected as lockdowns ease. This recovery is evident in recent credit and debit card spending trends, a significant upturn in auto sales, and a May retail sales report that showed the largest ever month-over-month increase. Activity in the travel and leisure segments of the economy also appears to have bottomed, reflected by a pickup in air traffic, restaurant bookings, and vacation rentals. While these economic data points are still significantly lower compared to 2019 levels, the inflection point of the recovery is clearly at hand.
It is not easy to separate the recent economic improvement and rally in equity markets from the unprecedented monetary and fiscal stimulus efforts. The flood of money from the Fed and other global central banks has been able to reverse most of the damage in credit markets since March, and ample liquidity has been a contributing factor to expanding equity valuations in our view. And the liquidity spigots are expected to remain wide open for the foreseeable future. The Fed has signaled their intentions to keep interest rates at near-zero levels for the next several years. On the fiscal side, Congress is working on phase 4 of the economic stimulus plan with size estimates ranging from $1 trillion to $3 trillion. Policymakers’ “whatever it takes” mantra is growing more apparent by the day, and financial markets have gotten the message.
Despite the positives and stabilization, many investors are questioning if the stock market has moved too far, too fast. Stocks have moved from the cheap zone to optimistic valuation levels in the span of three months. It’s not a controversial statement to highlight that stocks have shaken off a lot of bad news during the ascent, leaving investors to ponder at what point the immunity to the negatives wears off. Another logical concern is if elevated valuations leave any cushion for unanticipated outcomes such as a second wave of COVID-19 cases, a new trade war, or geopolitical miscalculations. As always, there are a host of concerns and potential negative outcomes that could translate into a spike in volatility and a market correction or at least consolidation after a massive run.
However, there is a significant concern that has been removed from the worry list. Slipping into a recession is no longer something that keeps me up at night. The current unemployment rate is above 13%, and the Federal Reserve Bank of New York estimates that second-quarter GDP will contract by 20% on an annualized basis. The recession outcome has already unfolded. There is plenty of room for debate about near-term economic outcomes. But the playbook points to recovery and expansion as the next phases of the economic cycle. And given the depth of the current contraction, there is a long runway for the normalization process. The prior expansion lasted eleven years, produced a 524% total return (S&P 500 Index), and was one of the most hated bull markets in history. And like the current environment, it started when investors were most pessimistic.