Is this crazy or what? On the one hand we are in the middle of the worst economic collapse since the Great Depression and the worst medical crisis since the 1918 Pandemic. At the same time the S&P 500 has increased nearly 4% this year and the Nasdaq Composite is up a whopping 22%. We are increasingly worried about the essential things in our lives – income, career, families – and yet the stock market seems to be whistling past the graveyard. What gives?
We think there are four possible reasons. First, the Federal Reserve moved early and aggressively to backstop Main Street. The Fed’s balance sheet has almost doubled over the past year as it has bought just about everything for sale in order to calm credit markets. Congress came through with payroll protection for businesses and additional Federal benefits for the unemployed. Whether the initial stimulus will be enough remains to be seen but Wall Street has breathed a sigh of relief.
A second reason is a little nerdier. Stock prices are the sum of all future earnings discounted by an interest rate to reflect risk and alternative uses of money. When interest rates are high the discounted value of a company’s earnings is lower and vice versa. Right now interest rates are near zero which implies potentially sky-high stock prices.
The third explanation is that the economic shutdown in the winter was a one-time shock. When a vaccine is developed, and the optimists expect something soon, the economy will snap back quickly, justifying today’s higher stock prices. We are worried, however, that the economic recovery is losing steam now (see chart above).
The fourth explanation is the simplest and perhaps closest to the mark. It is the TINA argument – There Is No Alternative. With savings rates and bond yields near zero, investors, whether they are looking for appreciation or for income, see no alternative to stocks. Demand is pushing up the stock indexes.
And finally a word about the ‘Market.’ We mentioned that the S&P 500 and the Nasdaq Composite are up year-to-date. They are both capitalization weighted indexes, meaning the most expensive stocks have the greatest weight. Right now tech and communication services rule (see chart below). Amazon is up 71% this year, Netflix 52%, Apple 51%, Microsoft 34%, Facebook 30% and Google 11%. Ex out these stars, as the Value Line Geometric index of 1675 stocks does, and the average stock is down year-to-date by as much as 14%.
The world is very uncertain now, so make very sure you don’t pay too much for it. We prefer to stick to the cheaper parts of the market and not chase expensive stocks which have already discounted many years of future earnings.