Are Markets Really Being Rational?

Markets have come charging back after falling to a low on March 23, despite fears of an increase in absolute numbers of infections and deaths, slumping economic data, surging unemployment and a troubling rise in reported secondary COVID-19 infections. While numerous explanations have been offered for the sharp market recovery, none of them sit well with us. We have a general theoretical override on the desk: in the absence of any structural change, the market will continue to follow the current trend. This would suggest that equities have further downside, or at least that the market rally has limited upside.

Initial thinking is that signs of COVID-19 curve flattening indicate that social distancing and other government-imposed restrictions that have been killing economic activity are approaching their end. Other investors point to the massive backstopping of credit markets by global central banks, including the Fed’s huge $2.3 trillion packages. Then there is the “wall of liquidity” as investors seek respite from negative- or low-yielding government bonds and asset purchase programs. This includes the massive expansion of the Fed’s balance sheet, which now, mind-bogglingly, includes bond ETF purchases. (I guess the Federal Reserve has aspirations to run policy just like the Bank of Japan… I wonder how that will turn out?)

Then we have what is perhaps the most powerful investment screener of all: the herd mentality of “fear of missing out” (FOMO). FOMO is “a pervasive apprehension that others might be having rewarding experiences from which one is absent.” Having been programmed during the world’s longest bull market rally, investors were quick to rush back in. And, of course, volatility these days is always amplified by computer-driven algorithms that jump on market trends in milliseconds.

None of these rationales make sense. The flattening COVID curve (clearly a social positive) will limit the duration of constrained economic activity. In the end, COVID is an event like an earthquake or a flood: society will return to normal after a period of time. Therefore, demand shortfalls can be forecast and deficits managed through fiscal stimulus. The risk of large disorderly defaults has been reduced by government and central bank intervention. This is the same thinking that has been in play since 2008 and caused the risk premium to fall to almost zero. In a 2008-like move, central banks are expanding the money supply at an unprecedented rate, flooding banks with near-endless liquidity. And, finally, in keeping with the very definition of herd mentality, investors are in on it.

Yet there is still concern in the back of our minds. As Warren Buffet famously put it, “Only when the tide goes out do you discover who’s been swimming naked.” Our view as to what the future will look like remains extremely hazy. The mind-numbing collapse of crude prices and rumors of big defaults (oil producers lack hedges) highlight the degree of uncertainty. Massive US job losses and an unprecedented spike in jobless claims have stunned state agencies. Beyond the public health crisis and the resultant economic crisis, the US is likely entering into a devastating period of mass unemployment. Consumers, who account for 70% of US GDP growth, are likely to carry psychological scars, leading to tighter spending habits and an increase in precautionary savings that will keep demand weak for longer. Moreover, this conservative spending scenario will likely play out in every nation globally. We doubt Chinese consumers will simply “go back to normal”.

There are other unknowns as to how society will react in the post-corona world. Social distancing could become embedded in behavior, leading to questions over who is likely to go to football matches or rock concerts or travel in jumbo jets. In general, the path to effectively containing the pandemic is still littered with unknowns.

Corporations (with the exception of Netflix) are in survival mode, first and foremost trying to manage their staff with significantly reduced revenue. This means one of the biggest drivers of stock appreciation – share buybacks and dividends – will be halted.

Last but clearly not least, there will be a surge in public debt, followed at some point by suggestions that growth-killing austerity is needed to balance the books. Until that time, though, collapsing tax revenues and higher spending will see national debt-to-GDP ratios explode. This will be especially true in Europe and will challenge the EU to its core.
Global GDP is conservatively estimated to contract by 2-4% this year. By comparison, earlier forecasts, when analysts (including us) saw no compelling reasons for stocks to fall, were for 4-5% global growth. Given the uncertainty, it seems odd to us that global equities are within 15% of their 2020 global Goldilocks market highs.