What a difference a month makes! The S&P 500 was up a whopping 12.67%¹! That was the fourth-best monthly return over the past 80 years. There were several issues that contributed to the positive sentiment; such as bending the COVID-19 curve, progressive COVID-19 research efforts as well as fewer COVID-19 cases and fatalities than initially projected.
But wait a minute… this week witnessed the release of a -4.8% first quarter economic contraction. The weak economic performance is supported by many different data from manufacturing to unemployment to sales. How can the equity markets see record returns while the economy seems to be deteriorating?
In short, the stock market is not the economy. Although, the stock market is influenced by the economic cycle, the stock market reacts to information that changes predetermined expectations. The quick and efficient discounting of information is referred to as the Efficient Market Hypothesis in academic circles.
Generally, the stock market tends to focus future expectations. If new information is presented that differs from the expectation, the stock market can throw a temper tantrum. The COVID-19 experience is an excellent example. Prior to Feb 20th, the stock market was focused on a robust growing economy with little to no COVID-19 disruption. However, once the market recognized the potential economic impact of shuttered industries, the market began a swift month-long decline.
Fast forward to this week for a positive return with negative economic data. Investors have accepted a current recession as a fait accompli. Hence, data confirming a recession is a non-event for the stock market. Investors are already looking forward to the eventual recovery. Investors have focused on forward looking items, such as positive COVID-19 momentum, preparations for a return to normalcy and indications of pent-up demand.
Investors ultimately formulate expectations about company earnings. The COVID-19 impact mostly centered around leisure, entertainment and food services and retail sectors. These industries account for more than a fifth of U.S. employment, but only 7% of stock market earnings. Earnings, or companies’ economic performance, ultimately drive stock market performance. April’s record returns are likely a function of investors recognizing the earnings impact may not be as bad on initially projected as well as an oversold market.
Near term expectations are finicky. Yet, focusing on longer term expectations lends itself to more reasonable and appropriate portfolio design.
¹ Source: Morningstar Direct.
CRN-3067722-043020
Recent Comments