DISCONNECTED FROM REALITY?
The economy is reeling while the market is rallying, leaving many investors perplexed. Three potential explanations for the disconnect.
The financial markets have largely recovered from the sharp declines of February and March while the economy continues to deteriorate. How can this be? Doesn’t the world seem more damaged than current equity and fixed-income markets indicate? Arguments can certainly be made for a swift recovery, but a slower recovery is also a reality. In this short brief, I walk through some of the disconnect and attempt to offer perspective going forward.
Thanks to stimulus provided by the CARES Act and massive intervention from the Federal Reserve, the markets have become flooded with liquidity. Right or wrong, these government policies are intended to lubricate the wheels of the American economy. And the Fed has done this by purchasing bonds (quantitative easing) while simultaneously decreasing the level of short-term interest rates. These moves encourage investors—both on wall street and on main street—to take on more risk by lending more and investing more, as opposed to holding cash. When bonds, CDs, and liquid savings accounts offer little yield, many investors will turn to stocks in search of higher returns, thus pushing prices higher. Similarly, if the rate of interest is low enough, companies will borrow more capital because the cost of doing so is low. These activities demonstrate how the financial markets can surge while ignoring the longer-term issue here of too much debt and too many short-term assets chasing risky longer-term assets such as stocks.
As an aside, for those who are concerned about the government’s growing level of debt—it’s a serious issue. But in the short term, it’s worth noting that while the debt level may be growing, the debt service (interest payments on the debt) may actually remain steady since we’re now paying a lower rate of interest on this debt. Similar to refinancing a home and taking out additional equity—your debt level may grow, but if you refinanced at a lower rate, your payment may not change.
MARKETS ARE FORWARD LOOKING
It’s also worth remembering that the economy and the market are indeed connected, but they’re not the same. Much like two siblings from the same parents—they’re related, but they often behave in very different ways. One way in which the economy and market are different is that the market tends to look forward in anticipation of what’s to come. And the mar-kets seem to be looking beyond today’s economic woes and toward a future that may have a covid-19 vaccine, more relaxed social distancing standards, and more business and personal travel. It can also be said that in February and March, the markets were too pessimistic on the future when uncertainty around the virus was at its highest, and thus markets sold-off more than was warranted. Conversely, in the short-term, we may be in a period where the markets are over-bought based on too much optimism. It’s worth pondering: how far in the future does the market need to look before we see better days?
TECHNOLOGY LEADS THE WAY
As I wrote in July 2018, it’s important that investors understand which “markets” they’re invested in and what companies make up those markets. Here’s what I mean: when people refer to U.S. stocks, they’re generally referring to the S&P 500 index. But few investors are actually invested like the S&P 500. Instead, odds are they’re invested across a mix of small stocks, international stocks, value-oriented companies, growth-oriented companies, fixed-income investments, etc. Is it appropriate to compare an investor who is half invested in stocks, and half invested in bonds, to the performance of the S&P 500? What about just comparing the stock portion of their portfolio to the S&P 500?
The S&P 500—which holds 505 companies by the way—is weighted by market capitalization. This means the biggest firms represent more of the index as compared to smaller ones. As a result, it is skewed toward gigantic technology companies as they happen to currently be the largest public firms in the United States. The top 5 companies and their respective weightings are: Microsoft (5.52%), Apple (5.24%), Amazon (4.01%), Facebook (2.14%), and Alphabet (3.38% A and C shares combined).* These five companies account for more than 20% of the S&P 500. It should come as no surprise that technology firms have thrived during the work-from-home, safer-at-home policies brought on by COVID-19. Is it fair to say that stocks in general are painting a rosier picture than can be justified—or is it the case that technology stocks have (understandably) performed well, thus skewing the data?
It’s hard to deny the markets are faring better than expected given the current state of the economy. But just because we may think rationally about markets, does it mean the markets must act rationally? History tells us that market behavior can deviate from reality — both to our advantage and disadvantage – in the short run. The question many of us are asking is: “does it make sense to invest in a market that seems irrational at times?” The answer, of course, depends on the investor, their objectives, time horizon, and perhaps most of all— their ability to acknowledge that asset prices can at times become untethered from reality. I would submit that this risk of investing amid uncertainty is the price we pay for higher expected returns relative to more predictable and secure investments.
Lastly, I think it’s worth mentioning that the publicly traded capital markets do an incredible job of processing new information—and it happens almost instantaneously. As a result, the opportunity to consistently and efficiently capitalize on perceived disconnections is exceptionally rare.
Boring as it may be, my advice is this: if you have dollars set aside for a goal in the next few years, keep it out of the markets. But if your goal extends beyond a few years, the markets can still make sense, even if they become disconnected from reality at times.
Jeff DeLarme, CFP®
Registered Principal, Financial Advisor
The information in this writing has been prepared from sources believed to be reliable, but is not guaranteed by Raymond James Financial Services or DeLarme Wealth Man-agement and is not a complete summary or statement of all available data necessary for making an investment decision. Any information provided is for informational purpos-es only and does not constitute a recommendation.
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*https://finance.yahoo.com/quote/SPY/holdings/ June 23, 2020