Global stocks finished higher on optimism over the reopening of the economies and some positive news about progress on vaccine trials. Later in the week some caution returned that raised geopolitical tensions, as China planned to impose a new security law on Hong Kong and as a U.S. Senate bill was introduced that could force Chinese firms to delist from U.S. exchanges. We think investors can be confident in a longer-term recovery but should position portfolios and expectations to weather periods of volatility along the way.
Too Far Too Fast?
To be clear, we don't endeavor to predict or time short-term moves in the market, nor did we foresee the global pandemic and ensuing unprecedented health-crisis-driven recession. But we do acknowledge that even healthy markets take a breather.
Just four months later, the world is very different now, and those fundamental conditions have changed. The market has traveled quite a bit of ground in that time, including a solid gain last week, adding to what is now a more-than-30% rally over the past two months1. While the backdrop is starkly different from January, this rearises the question: Has the market come too far, too fast? Here are three takeaways to consider:
1. This rally is based on the future, not the present.
The market is up 27.9% since March 23, the strongest "bear-market rally" in the last 75 years and the sharpest two-month gain for the S&P 500 since before 19901. Stocks rose again last week as news of progress on vaccine development lifted optimism for the economic recovery.
The economy and the stock market are seemingly on different pages at the moment, as incoming economic readings reflect the severe downturn while stocks have endured a sharp upturn. While this may feel like a significant disconnect, it is not abnormal. The stock market is forward-looking. The 34% sell-off in February and March reflected uncertainty around the growing pandemic and anticipation of a resulting recession, but in the heat of the market pullback, economic readings were still displaying healthy pre-virus labor-market conditions1. Now, stocks have rallied at expectations that have leaped forward to the reopening of the economy and a rebound in GDP and corporate profits.
Incoming economic data will be somewhat backward-looking. Therefore, while new economic reports will show a rise in unemployment and declines in consumer and business spending during the second quarter, we expect the market to reflect expectations for the second half of the year and into 2021 and be more responsive to indicators related to COVID-19 treatments as well as progress on reopening the economy.
Bottom line: The recent market rally is an encouraging sign. The gain does not signal the "all clear," in our view, but, historically, strong rallies typically occur in the latter half of bear markets, suggesting we're making progress in this downturn. This rebound is pricing in the unprecedented policy responses from the Federal Reserve and Washington, along with a shift in focus toward the reopening of the economy. We think economic activity will rebound in the second half of this year, but we don't believe the economic reopening will proceed as rapidly or as smoothly as the 30% market rally seems to suggest1. We don't think this means the gains will have to be given back, but we do think, given the strength of the rally, that periodic disappointments or setbacks will be met with episodes of market volatility.
2. Recoveries take time.
The stock market can and will move faster than the economy, but the two are connected, and over time, the path for the economy sets the foundation for market performance over the broader term.
For perspective, this bear market is three months old. Looking back at the last four bear markets, the average time from the market peak ('80, '87, '00, '07) until stocks rebounded to that previous high was 49 months2. We'd note, however, that the bear markets in '80 and '87 averaged a decline of 31% and each took 23 months to return to the previous peak2. The two most recent bear markets experienced 50% declines, with the time to return to previous highs taking more than twice as long2.
Looking at those same bear markets, the average time from the bottom until the market regained its previous high was 2.5 years. Again, however, the recoveries from the 30% declines in the earlier two were significantly shorter versus the recovery time from the bottom of the 50% pullbacks2.
In terms of the economy, since World War II, it took an average of just over one year for the economy to bottom during recessions, and an average of nearly two years for the economy to return to pre-recession GDP levels.
Bottom line: We think the self-induced nature of this recession will lead to a faster-than-average bottoming of the economy, with our expectation that the recession, which presumably began in March, will likely experience the worst of the contraction in the second quarter. That said, given the magnitude of the downturn and the lasting impact this will have on certain industries and geographies, we think it will take an extended period of time for the economy to return to pre-pandemic GDP. The upshot for investors is that support for broader market performance does not require an immediate return to pre-recession output, but instead stocks can and should benefit from sustained improvement in economic conditions, which should foster a rebound in corporate earnings. For example, while it took 3.5 years for GDP to recover following the Great Recession of '08/'09, corporate profits rebounded more quickly, supporting solid stock market gains in 2009 and 20101.
3. There is reason to be optimistic while also realistic.
We think the pendulum of market sentiment has swing decidedly more positive lately. Optimism around an enduring economic recovery is not misplaced, but should be appropriately calibrated. Last week's reading of initial jobless claims showed that unemployment is still on the rise, but the pace of job losses is slowing from recent levels. We think the progressive reopening of state and local economies will unlock a portion of pent-up consumer demand and deliver an initial stage of labor-market improvement. This should help stabilize the economy and create an initial foothold for the economy to begin its climb.
At the same time, we think the market is pricing in a somewhat smooth reopening of the economy, meaning evidence of setbacks or slower progress pose potential risks in the near term. At this stage, we think the market has priced in the severe downturn in GDP and accompanying temporary spike to historically high unemployment levels. That said, we don't think a prolonged recession extending well into the second half of the year is fully baked into the cake. We don't think that is the most likely outcome, but we're watching the potential for a renewed flare-up in new COVID-19 cases (either seasonal or as quarantine measures are relaxed), evidence of a slower-than-hoped return of economic activity, and/or lasting damage to the labor market as potential instigators of market volatility.
Bottom line: We don't think this recent sharp rally is built completely on sand, but we don't expect it to persist at the same pace or magnitude uninterrupted. We anticipate upcoming virus, economic and earnings data to display a mixture of encouraging green shoots as well as periodic setbacks. With expectations growing more positive and markets logging strong gains, occasional disappointments are likely to be met with bouts of market volatility. Investors should prepare with
Appropriate, realistic expectations for near-term market swings and longer-term returns;
Periodic portfolio rebalancing, taking advantage of opportunities to trim overweight allocations and add to lagging areas that are attractively priced; and
Ensuring appropriate diversification and quality within portfolios. A broad mix of domestic and global asset classes, as well as investments in companies with diverse, reliable business mixes and strong financial positions, can help prepare your portfolio for any uptick in market volatility while also positioning it for the longer-term recovery.