Why has the stock market been rising?

Special Halftime Report from Forstrong Global, Part 1

At its midpoint, 2020 is already a year for the history books. But what could lie ahead for the remaining half? Never mind a possible second wave that could sweep the globe. The pandemic has unleashed a new surge of social discontent not seen in decades.

Politics, especially in America, have spilled onto the streets. Borders, once free and frictionless, have suddenly become impervious, diverting the world’s collective wanderlust to more angst-driven pursuits. Whispers have turned to shouts. Fractures have deepened. Trump’s Twitter account, ever adept at picking at established fault lines, has become even more belligerent. Europe’s national divisions have again been painfully exposed. The backlash against China’s economic rise has gathered momentum. And, in today’s burgeoning list of “new realities,” it is now Kanye West announcing and then withdrawing his presidential candidacy (is anyone surprised?).

So much for summertime and easy livin’. And yet, global markets have staged a revenant-like revival since March 23 (chalking up the best 50 trading days ever in the S&P 500’s history), catching many investors flat-footed and fumbling for answers. How could this happen amidst such a tense backdrop? Are we now in the largest economic shock since the Great Depression (with most of the world on house arrest)? Many Wall Street icons have denounced the rally. Some predict new lows ahead. Meanwhile, investors are witnessing a split-screen narration of the crisis – a tussle of facts and opinions seemingly pulling in opposite directions.

All of which brings us to a key “what next?” moment in time. How to make sense of all of this? In this series, which we call our “2020 Halftime Report,” we tackle the seven most pressing questions from our clients.

Question 1: Stock market strength seems to be completely divorced from the underlying economy. What’s happening here?

By far, this is the most common question we have received over the last month. Now, to be sure, today’s fundamentals are abysmal. Global GDP and earnings have plunged. Mass unemployment has soared around the world. Many business models have been gutted and face an existential threat. Some companies will now have higher costs due to supply chain issues and health concerns. Others have ratcheted up capital buffers, lowering capital spending and expansion.

Yet, it is wrong to say that the stock market must fall to match a depressed economy. Financial markets are always anticipatory. While humans naturally think in terms of “good or bad,” markets think in terms of “better or worse.” In other words, markets are not pricing the world as it is, but the world as it may become (we often repeat this mantra around the office, reminding ourselves that markets are second-derivative thinking mechanisms).

So why have stocks soared since March 23? Some scene-setting is helpful. On March 26, we issued a comprehensive report entitled “Investing in The Time of Coronavirus.” At the time, we urged investors to take on risk (our investment team substantially raised risk for all clients on March 24). “The conditions for a meaningful rally are here…investors must act now,” we wrote at the time.

We do not mention this to take a victory lap, but rather to highlight forward-looking markets at work. Why were we bullish? Not because we believed the current situation was good. In fact, everyone knew growth and earnings would collapse in the coming months. Rather, we were constructive on risk because our investment process showed such universal pessimism that upside surprises would become easier to deliver. The worst scenarios were already priced in – far worse than the “end cycle” fears that plagued the pre-virus world.

Time and again, investors who have taken on risk during our darkest days have ultimately been rewarded. Yet most investors stared into the abyss in March and concluded that the bottom was nowhere in sight. But, at the time, positive surprises could have come from several developments — the underlying economy, vaccine developments and, most importantly, policy stimulus (more on that in a future report).

Today, the world looks much different. The Citigroup U.S. Economic Surprise Index, which tracks economic data relative to economist expectations, just hit its highest level in history. In fact, dozens of data points are improving, whether measuring housing, auto sales, or retail activity. Arrows are now pointing up and to the right.

As it is, expectations remain gloomy. Not to the extreme level of March’s under-positioning and skepticism (and, to be sure, there will always be a non-trivial segment of the investing population that only seems content predicting the end of civilization). Bank of America Merrill Lynch’s global fund manager survey sheds some light on the subject. The latest survey from mid-June reveals that a record 78% of fund managers believe that the stock market is “overvalued,” the highest in 22 years. 53% say it’s a bear market rally. The report concludes: investor sentiment remains “fragile, neurotic and nowhere near dangerously bullish.”

A final point: When people speak of “the market,” most investors think of the S&P 500, the Nasdaq, or some other broad U.S. index. Now, it is true that these indices have been soaring. But this is on the back of a handful of U.S. tech darlings (which are up 54% this year). That masks carnage beneath the surface. Some sectors in the U.S. (financials and energy) and many stocks around the world are still more than 30%-40% below their pre-Covid highs. European banks trade on 37% of book value. Many emerging market countries are back to the same levels as 15 years ago.

Perhaps the current disconnect is not so large?

As always, at Forstrong we welcome your feedback. Our investment team, a collective of long-distance readers and researchers (with a combined 157 years of global investing experience), stand ready to respond to your questions.

Next time: The risk of a second-wave COVID-19 pandemic and the shape of recovery.

Tyler Mordy, CFA, is President and CIO for Forstrong Global Asset Management Inc., engaged in top-down strategy, investment policy, and securities selection. He specializes in global investment strategy and ETF trends. This article first appeared in Forstrong’s March 26 issue of “Ask Forstrong,” available on Forstrong’s Global Thinking blog. Used with permission. You can reach Tyler by phone at Forstrong Global, toll-free 1-888-419-6715, or by email at tmordy@forstrong.com. Follow Tyler on Twitter at @TylerMordy and @ForstrongGlobal.

Notes and Disclaimers

The foregoing is for general information purposes only and is the opinion of the writer. The author and clients of Forstrong Global Asset Management may have positions in securities mentioned. Commissions and management fees may be associated with exchange-traded funds. Please read the prospectus before investing. Securities mentioned carry risk of loss, and no guarantee of performance is made or implied. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.