The S&P 500 Index rose again on Wednesday (June 3), closing at a three-month high and paring the market’s drawdown to a relatively mild 7.8% decline — a shadow of the nearly 34% drawdown at the height of the correction on March 23. Fueling the market’s rebound is the view that the worst of the coronavirus recession has passed and the recovery is coming into view. Is this wishful thinking? Or is the crowd’s implied forecast valid? The future, as always, remains unknown, but let’s consider the pros and cons of Mr. Market’s outlook for some perspective.
We’ll begin with a highlight that supports the optimistic case: emerging signs that the recession deepest point has passed, or so it appears based on data published to date. Consider the recent evolution in the revisions to the Philadelphia’s ADS Index, a multi-factor business-cycle benchmark that serves a real-time measure of US economic activity. The chart below shows how the index has been revised this year as new numbers have arrived. The latest vintage (for data through May 23) indicate that the deepest level of the recession has passed. The bad news: there’s still a long road ahead before ADS returns to a level that reflects growth.
Indeed, the gap between the current ADS level and what’s considered a growth profile is an economic chasm. Like so many other economic indicators, the ADS Index’s decline was unprecedented in modern times in terms of speed and depth. The big unknown: How fast will the recovery unfold?
The stock market’s ongoing rebound, however, implies that economic recovery, if not yet tangible, is near and will be robust and relatively speedy. Maybe, but as the market races higher, the risk of disappointment lurks and so in theory equity prices become increasingly vulnerable to a setback.
“The markets are priced to perfection,” Danny Yong, a partner at hedge fund Dymon Asia Capital in Singapore, tells the Financial Times. “The stability in equity markets does not reflect the job losses and the insolvencies ahead of us globally.”
Deciding if the market is accurately pricing in the economic road ahead is challenging for the simple reason that no one knows how the coronavirus crisis will evolve. For now, it appears that the pandemic has peaked in the US. For example, the daily change in fatalities continues to trend down after topping out a month ago.
The critical question: Will there be a second wave later in the year?
“We’re still on the first wave, but…I think it’s completely inevitable that we’ll have a second wave and probably a third wave…Until we get a vaccine, we’re going to be in danger of repeated waves of the pandemic,” says Dr. Irwin Redlener, a pediatrician, a professor at Columbia University’s Mailman School of Public Health and the director of the National Center for Disaster Preparedness at the Earth Institute at Columbia.
The recent protests over the death of George Floyd are feeding worries that the return of crowds in public spaces will be a factor in seeding a new rise infections. Although the protests aren’t the only factor that may lead to a second wave (Memorial Day holiday gatherings are another possible catalyst), the risk linked to the protesting has focused attention on how the rest of the year may evolve with respect to Covid-19.
“It’s heartbreaking on a number of levels, for sure from the infectious diseases and epidemiology levels,” says Dr. Katie Passaretti, medical director for infection prevention at Atrium Health in Charlotte, North Carolina. “You have big groups coming together and people from far apart places coming together. It’s a risk for spread of Covid.”
The general reopening of the economy is certainly a factor, too, and one that comes with risk. Ditto for the upcoming return of students to school in the fall – labeled as “one big experiment,” as ABC News recently noted.
Despite the uncertainty, and the high stakes linked to the outcome, the stock market at the moment appears to be downplaying the potential for negative surprises. Keep in mind, however, that the market’s rebound is partly due to a snap-back effect that typically occurs whenever equity prices crash, as they did in late-March and early April. Even if there were no signs of economic recovery on the horizon, the market would probably bounce in some degree. The mystery is whether the current revival is just a technical reflex or if it also factors in a fundamentally based assessment that the economy will quickly recover.
Reviewing how current market conditions compare with the ten deepest drawdowns since 1950 for the S&P 500 remind that the usual path is a lengthy run below the prior high point. As the chart below shows, in some cases the market rebounded partially and then moved sideways for an extended period. There were also instances when a rebound following a crash ran out of steam and new lows soon followed.
Deciding which path will prevail this time is guesswork. Much will depend on the incoming economic numbers and Covid-19 data.
The Capital Spectator’s baseline outlook for the near term is that as long as the data continues to show that the recession is easing, that’ll satisfy the Mr. Market to keep stocks prices rising.
Although the main economic indicators have fallen off a cliff lately, investors are apt to treat signs that the worst has passed as good news, which it is. But there may be a reckoning lurking in the near future. At what point does the optimism born of learning that the recession’s deepest point has passed give way to realizing that a harder challenge awaits in putting millions of unemployed workers back to work to fuel growth?
For the moment, the market seems to be enamored with the news that off-the-chart job losses have given way to a lesser collapse. Consider yesterday’s ADP Employment Report for May: US companies shed 2.76 million jobs last month. That’s huge loss, but compared with a near-20 million decline in April it looks encouraging.
Until the labor market starts showing robust, sustained growth, however, the sugar high of seeing job losses that no longer reflect an economic apocalypse could wear off, replaced by the recognition that repairing the damage will take time.
“I would say the economic data is old news for the market’s purposes,” says Preston Caldwell, senior equity analyst at Morningstar. “Right now, most market participants are looking beyond the [second quarter] to try to understand the second half of 2020 and beyond.”
By that logic, the stock market is effectively telling us that the recovery will be relatively swift and robust. Let’s hope. But this is a forecast, and one that’s subject to revisions on a day-by-day basis.
“The good news is I think the recession is over, the Covid-19 recession is over, barring another second wave, a major second wave, or real serious policy errors,” notes Mark Zandi, chief economist at Moody’s Analytics. He adds, however, that “the recovery will be a slog until there’s a vaccine or therapy that’s distributed and adopted widely.”
The challenge for investors is deciding if the market is fully pricing in the risks ahead.
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