The question I get most often from clients is, “Why is the stock market doing so well when the economy is suffering?” For most of the summer, the stock market has been buoyant. According to Barron’s, equity investors are up $13.1 trillion or 55.7% from the March 23rd lows and up $2.2T or 6.3% since the end of 2019, even after last week’s tech wreck. (see commentary below). Yet nearly 11 million of the 22 million people who lost their jobs in last spring’s lockdown remain out of work and roughly 155,000 small businesses have permanently closed since March.
Why the dichotomy between Wall Street and Main Street? My answer is, “It is all about building bridges.”
In answering my clients’ question, I usually start out by explaining that they are not invested in Main Street. Their portfolios contain mostly large or mega-cap companies. Many of these corporations have sufficient resources, cash and strategies to survive the crisis. These same lifelines are often not sufficiently available to individual families and small business owners on Main Street.
Wall Street learned from 2008 that if it shores up its balance sheets at the beginning of a crisis, signaling it could weather the pandemic, investors would be forgiving and look beyond weak current earnings to stronger future earnings. And that is exactly what investors are doing.
There is an adage that says that the stock market looks ahead; its pricing is based on what the market thinks will happen 9-12 months from now. Currently, the market believes that by early next summer, the COVID crisis will be contained. While COVID will probably not disappear, the belief is that society will have learned to live with the virus with the help of vaccines and therapeutics. Moreover, investors are counting on businesses and consumers returning to their old spending habits or developing new ones, allowing the economy to pick up approximately where it left off last February. There is a caveat to this belief, and that is where the bridges come in.
Wall Street has benefited from a bridge built by the Federal Reserve. Back in February, the credit markets started to crash (yes, it was not only stocks that were in trouble last March) as businesses sought to raise cash amid frightening uncertainty. Buyers fled the credit markets, causing the fixed income markets to start seizing up. The scariness lasted only a few days, however, because the Federal Reserve was quick to step in. Being independent, it could act fast and it had the tools (a legacy of 2008) to prop up the credit markets and large businesses. Its tools were a combination of quantitative easing (flooding the markets with cash by buying up US Treasuries, mortgages, and for the first-time, corporate bonds) plus reactivating and expanding its lending facilities. This meant that big companies could borrow at extremely low interest rates to keep themselves afloat, and they could count on a buyer of last resort – the Federal Reserve – to buy their debt. The Fed’s goal was to keep liquidity in the markets. If money was flowing through the system, then defaults were much less likely, and businesses could stay alive until the crisis had passed. Coincidentally, just as during the aftermath of the 2008 financial crisis, some of the 2020 Fed’s monetary infusion ended up in equities, helping to prop up the stock market this past summer.
To top it off, Jerome Powell, the Chair of the Federal Reserve, recently assured corporations and investors that the Fed isn’t even thinking about discussing the possibility of raising interest rates or cutting back on the flow of money. Investors have every reason to believe that the Fed Bridge will last until 2022 and maybe a few years longer.
Main Street hasn’t fared as well. Unfortunately, the Federal Reserve cannot help small businesses and the unemployed remain solvent. That must happen through fiscal policy (spending/taxation) which is determined by Congress. While Congress started building its bridge for Main Street this Spring, through small business loans (PPP), stimulus checks and generous unemployment benefits, those provisions of the CARES Act ended in August. Metaphorically, the Congressional Bridge has been halted high over troubled waters. Without continued fiscal support, the recession that started last spring could last beyond the end of the health crisis, jeopardizing the recovery of both the economy and the stock market.
For now, the markets believe that Congress, following its tendency to practice political brinksmanship, will pass another round of stimulus this fall. The threat of a government shutdown at the end of September could be a good catalyst for bringing the sides together to provide much needed income replacement until sometime next year.
What will the stimulus look like? In all likelihood, it will include money to fund more PPP, an eviction moratorium, additional unemployment insurance, direct tax refund payments, state and local aid as well as some liability protection for businesses – all at a price somewhere between the current demands and caps of the Democratic and Republican parties.
There are still risks, however. First and foremost, Congress could fail to extend its relief package long enough, leaving too many without a sufficient lifeline to weather the crisis. Wall Street could also be too optimistic about the potential for safe, effective and timely vaccines and therapeutics. And consumers and businesses could continue to be reticent to spend, even after the greatest danger from the pandemic is over.
Until the economy can get back up and running smoothly, we need two bridges – one for Wall Street and one for Main Street. The biggest risk is pulling back on income replacement relief too early, stranding Main Street. Should that happen, Wall Street’s Fed Bridge could be at risk and so could its booming summer rally.
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Last week was a telling reminder, that bridges or no bridges, certain stocks are vulnerable. It has been a long time coming, but the current top mega tech stocks –Facebook, Apple, Amazon, Microsoft and Google (FAAMG) — experienced their first rout in a long time, falling an average of 7.1% last week, wiping out $522 billion of value on Thursday and Friday. Since these stocks make up 25% of the S&P and 47% of the Nasdaq, the tech collapse led the indices down as well. For the week, the S&P gave back 2.3% and the Nasdaq fell 3.3%. Is this the beginning of the end for big tech? Not likely. But it could be a healthy tech correction.
There are two interpretations of what happened last week: the rational and the technical.
The rational explanation is tied to headlines: the tech stocks were simply too frothy; a vaccine might not be approved before the election; Congress could fail to pass a new stimulus package; companies could pull back on tech spending as the work-from -home phenomenon winds down; the election results could lead to uncertainty; etc. Any of these explanations will do; the tech stock melt-up simply could not go on forever.
There was also an interesting technical version of the catalyst for the rout: unusual stock option activity. Much goes on behind the scenes of daily trading. Very occasionally, these activities can cause major stock market gyrations (e.g. flash crashes, high frequency algorithmic trading glitches; volatility derivatives spikes, etc.). In this case, as tech stock prices skyrocketed, bets placed through call options by businesses (SoftBank Group the biggest offender) and day traders became skewed, forcing further stock purchases and contributing to the tech super rally. That is, until the trade ended, and the pile-on became a pile-off, as trading excesses are inclined to do.
The tech story isn’t likely to be over; mega tech company strategies are providing winning solutions to pandemic problems and are likely to offer growth leadership once the crisis is over. But for now, the tech disruptors have been disrupted themselves.
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