The stock market has continued its recovery from the low on March 23rd. It has done so in the face of declining oil prices (another unprecedented market occurrence). Today, despite worse than expected Q1 GDP, the market is up mostly because news of a Gilead drug to treat COVID-19 patients. A good question we have been hearing is: why does the stock market continue to advance when economic conditions look so bad?
Historically, the market usually goes down more than economic conditions; for example, in 2008, GDP contracted by “only” 5% and yet the stock market went down 50%. Time will tell what will happen with this crisis, but this recession is one that we intentionally created for the sake of public health. As we have said many times before, the market is a forward-looking discounting mechanism, each day, digesting news and pricing it in into the future.
Andrew Adams, of Saut Strategy, had this to say today:
“Before all this Coronavirus mess happened, one idea I had given a lot of thought to over the years was that the stock market tends to “melt up” unless presented with a very good reason not to do so. That reason could be technical, fundamental, or breaking news-related, but absent such a reason the market does seem more likely to go up than down. Even during secular bear market periods, there are still large bounces and prolonged investable rallies that take place (e.g. 2003-2007), which is why true long-term investors don’t have to necessarily time the market perfectly to make money. It’s also why the old adage that you should “never short a dull market” is one to remember.
I know I’m not breaking new ground with this “theory,” but I do believe it’s important for market participants to comprehend that in addition to the fact that economies tend to expand over time, there are just more incentives for the market to go up than to go down: companies want their stock prices to rise; investors want stock prices to rise; and since the stock market is often viewed as a sort of scorecard for a political administration’s policies, the government wants stock prices to rise.
Even the so-called “independent” Federal Reserve seems to put more emphasis on being accommodative to maximize employment (which helps the economy and by extension stocks) than they do being more contractionary to prevent future high inflation. Is it really a surprise then that stocks frequently seem to go much higher than many believe they should? There are definitely times when a more negative or cautious view is justified, but it has to be supported by what the market is actually doing and not just what we think it should be doing.
I mention the “melt-up market” idea because coming into yesterday it felt as if stocks had returned to the “slow and steady” grind higher that had been the norm prior to this year’s large sell-off. The recent action has added to the tremendous amount of disbelief among many investors as to how the stock market can possibly go higher given that much of the economy remains shut down and likely won’t fully return to something resembling normal for a long while. Over the last month, the stock market has largely ignored the poor economic data and the continuing troubles suggested by the oil market, and it’s easy to make a case for why the market is “wrong” to do so.
Of course, the market is never wrong (though it can change its mind), and as a forward-looking discounting mechanism it is constantly reevaluating its outlook even as many individual investors remain married to their own.
In addition to the upward biases mentioned above, there are also trillions of dollars in financial capital worldwide that are constantly seeking out the best place to make a return. And with global interest rates at such ridiculously low levels the stock market is still the most attractive place for many global investors who need to earn something on their capital despite the existing risks. So, even if it has not made sense how stocks can possibly rise given all the existing uncertainty, the markets don’t have to make sense and stocks usually do go up unless the market decides there is a good enough reason not to do so.“
To his last point, investors have to put their money somewhere. All portfolios are made up of some combination of stocks, bonds and cash. Stocks give you the best chance for growth over the long term. Pension funds, endowments, wealthy people and all investors need growth from their portfolios. This is not a new idea, the term “TINA” – there is no alternative – to stocks has been written about before. However, as interest rates continue to go lower, investors do have to look to stocks for their growth. This could also mean more volatility in the stock market now and going forward. With interest rates where they are, investors will not get that growth needed going forward in bonds. You could get a decent income from bonds in the past as this chart will show, but the best indicator of future performance for fixed income in the starting yield, and we are starting from a very low point.
So why own bonds at all?
The reason is, everything is okay in the stock market and the economy until it isn’t. As we have seen in the past few weeks, the stock market can turn on a dime and there may not be a warning that there is a pandemic coming or whatever else will be thrown at us in the future. Everything was going just fine in the stock market and the economy in February until it wasn’t. We do not own bonds in our portfolios to outperform the stock market. We fully expect bonds will underperform the stock market over a long period of time. We have bonds because we want to make sure when things are not going well for stocks, and we aren’t sure exactly when that will be every time, we want to have bonds to meet your income needs in the shorter term. For example, in the Global Balanced Advisor, we have 5% in cash and approximately 20% in bonds. That’s 25% of the portfolio not invested in the stock market. If you are taking 6% in account withdrawals each year, that is approximately 4 years’ worth of account withdrawals without having to sell the stocks in the portfolio. We know over time, stocks will recover, and historically they have outperformed other assets over the long-term. By including bonds and cash in the Global Balanced Advisor portfolio, which is managed to moderate risk, this portfolio has the “staying power” to endure declining market periods.
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Regis R. Dillon, CFA, CFP®
Chief Investment Officer