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Why is the Market Going Up When Economic News Looks Grim?

Many investors are asking this question: How do we reconcile the recent U.S. stock market gains with the poor state of the economy and the weak outlook?

An answer involves recognizing that financial markets are forward-looking. Current pricing reflects expectations of the future. Markets are always incorporating new information and comparing it to current expectations. Investors are asking: Am I surprised by today’s news? Are things getting better than what I expected yesterday? Are they getting worse? Or are they about what I expected?

For example, 21 million people became unemployed in April (a month-over-month spike never seen before in U.S. history). The unemployment rate rose to 15%. That was terrible news. However dreadful this sounded, it was already widely expected. Thus, the stock market did not sell off, as it had already factored in this news in advance. It wasn’t a negative surprise.

The Stock Market Has Moved Higher Despite Historic Unemployment

So, why does the market continue to rally in the face of negative news? No one knows for sure. There are many variables that impact investor behavior. After all, financial markets are like any other market: Prices are determined by the intersection of supply and demand at any given time.

The recent rally shows that investors think things are moving in the right direction. They seem to view the economy as a patient placed in a voluntarily induced coma, with government policy providing life support. Investors hope the spread of the virus can be suppressed until we can resuscitate the patient and return to normal. They appear to be anticipating a rebound in the economy and employment, starting in the second half of the year. This is based on a number of factors:

  • Virus Spread: On the medical side, investors are clearly optimistic that the “flattening of the curve” will allow states to reopen and economic activity to restart.
  • Government Stimulus: The market was also encouraged by the government’s fiscal and monetary policy response to support the economy and financial markets while much of the economy was shut down.
  • Profile of Unemployment: About 80% of the 21 million newly unemployed workers in April say they are temporarily furloughed. If true, those workers could be quickly rehired and the recovery could be more rapid than is normally the case coming out of a recession.

Despite the strong equity rally (the S&P 500 is now down only about 8% in 2020), a great disparity has emerged underneath the surface of the broad stock market’s performance. Big Internet/tech stocks (names like Amazon.com, Netflix, and Microsoft) have generally held up well this year or rebounded strongly. The tech-heavy NASDAQ Index is positive for the year. In contrast, economically sensitive stocks in energy, financials, and other “value” areas have lagged. They are down around 20% so far this year. This suggests investors remain concerned whether a strong economic rebound in the near term is likely. For many, it appears safer to “hide” in those areas of the market that have done well so far.

We all hope the optimistic scenario that the overall stock market is currently factoring in plays out and life returns to normal. But hope is not a strategy. From an investment perspective and based on our understanding of the virus and all the unknowns still associated with it, we think that a near-term positive outcome is far from certain. There is significant risk that the market’s current outlook is overly optimistic. Should that be the case, sometime in the next several months, the incremental news could be very disappointing relative to current expectations. We would then expect stocks to decline.

We don’t have certainty or even a high degree of confidence in any particular scenario playing out. Rather, we prepare for a number of scenarios, both personally and as investors. After the recent market rebound, our five-year return outlook for the U.S. stock market is still not terribly attractive. Our base-case scenario expectations show low-single-digit returns for U.S. stocks, and this drives most of our tactical portfolio allocation decisions. So at current market levels, we remain slightly underweight to U.S. stocks versus our neutral allocation. We will wait for a better buying opportunity.

If you would like to talk further about your own portfolio and allocation, please reach out to your Investec Wealth Advisor. We are here for you and are happy to talk through the right strategy for your situation.