This Insights article was contributed by Dr. William Sackley, Director of BB&T Center for Global Capitalism and Cameron School of Business Professor of Finance.
The stock market, as gauged by the S&P 500 index, just completed its strongest calendar quarter of appreciation during the 21st century, albeit following a dismal first quarter. At this writing, the index is down just over 4% year-to-date, or just over 8% from its February high. That is fairly amazing in the presence of a global pandemic that appears to be escalating rather than abating in the U.S., and which has resulted in a larger disruption of economic activity than during any downturn subsequent to the Great Depression. Should investors be complacent about their equity exposure at this point, or “heading for the exits?”
Indications are that significantly fewer investors shifted out of equities during the February-March decline of 34% than occurred during either the dot-com crisis (circa 2000-2002) or the Financial Crisis (circa 2008-2009). Does this indicate that investors are becoming less emotional in the face of market volatility, perhaps because the market recovered from the Financial Crisis relatively quickly?
Using only price levels, as opposed to including dividends or adjusting for price levels, the Dow Jones Industrial Average (the S&P 500 was yet to be created) took 25 years to recover following the Great Depression. Again using price levels, the NASDAQ, hardest hit of the indices, took up to 15 years to recover from the dot-com crisis.
For the Financial Crisis, the S&P 500 required only between five and six years to recover its prior level. Perhaps more important, the Financial Crisis introduced investors to a Federal Reserve that was more accommodating than in the past, specifically in the level and duration of targeted (short term) interest rates, and accompanying asset-purchase programs. Have investors grown to believe that the overall risk of equity investing has been slashed by the Fed’s proclivities?
The Fed’s balance sheet, still inflated from the Great Recession, is up approximately 70% during 2020, and Chairman Jerome Powell has all-but-promised that interest rates will remain untouched for the next two years. The liquidity injected into the economy has to go somewhere, and a fair amount ends up in the stock market, especially given that bond yields point to negative real rates of return.
But wait! Perhaps the Fed has had exerted less influence on asset prices than surmised. Possibly current market levels can be explained through the stock market’s forward-looking nature – thought to focus on the expected environment approximately five months into the future. By that time, we could conceivably have an effective vaccine. By that time, we should know the outcome of the Presidential election.
As this is being written, the second consecutive stronger-than-expected monthly jobs report was just released (2 July: +4.8 million jobs, following May’s 2.5 million increase). Perhaps a speedy recovery is still in the cards – the proverbial “V-shape” rather than something akin to an “L-shape.” Indications appear to be building, however, that further recovery could be considerably slower than recent jobs reports inspire. Forecasting risk seems to be slanted to the downside.
So how can we decide whether the current level of the stock market is justified or “atmospheric?” Here are some factors favoring “justified.”
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