If the Economic Outlook is So Bad, Why is the Stock Market Going Up?
Each week, COVID19 related shut downs continue to generate bad news headlines. However, when one looks at the stock market rallies, one might make the mistake of thinking that the worst economic news is behind us and it’s safe to get back into the market.
Explanation #1: The Stock Market Rally is Lagging the Recession Data
The first reason why the stock market might be rallying in spite of poor economic data is because the stock market is lagging recession data. As David Kostin, Chief U.S. Equity Strategist at Goldman Sachs pointed out last week, during the Great Recession, the stock market didn’t bottom out until we were well into the recession:
“[I]n [Q4 2008], there were many different rallies, they’re called bear market rallies, some of which were almost 20% a couple of times, but the market did not bottom until March of 2009.” (Source: CNBC)
Unemployment currently stands at 11% to 12%, surpassing the 2008 Great Recession, but still not as bad as the Great Depression where unemployment was at 25%. However, as the lock-downs from the Pandemic continue, unemployment will likely increase, with some predicting unemployment to reach 20% to 30%. (The Hill: JPMorgan Predicts 20% Unemployment; Bloomberg: U.S. Jobless Rate May Soar to 30%)
Over the next few months, we’re likely to see the cascading effects of the shutdown as more and more industries get impacted like falling dominoes.
- First, we have businesses directly affected by the shutdown like restaurants. (The Denver Channel: 3% of US restaurants have permanently closed due to COVID)
- Second, we’ll have indirectly affected businesses like say the landlords of those restaurants. (AdWeek: With Rent Due, Leases Don’t Give Retailers and Restaurants an Easy Out)
- Third, we’ll see see a third order effect when those commercial real estate landlords — 70% of whom are banks — are seeing reduced revenues. (The New York Times: Pandemic Exposing ‘Cracks’ in Financial System, Bank Losses Likely: IMF)
- Fourth, we’ll see banks tighten credit. (Forbes: Mortgage Loans Get Harder to Come By As Lenders Tighten Standards)
- Fifth, we’ll see state and local governments facing budget shortfalls due to loss of tax revenue and start operating at deficits. (The Philadelphia Inquirer: More than 2,100 U.S. Cities Brace for Budget Shortfalls Because of Coronavirus, With Many Planning Cuts and Layoffs)
This is just a snapshot of the data coming out in the past two weeks. It takes time for the shockwaves to pass through the economy. Think of a brick and mortar store retailer and all of the industries dependent on it — not just directly like labor but indirectly like vendors. Vendors like accounting firms, financing providers, advertisers, media companies that depend on those advertisers, etc. Once this data becomes glaringly obvious, we’ll likely start seeing the market bottom out.
Explanation #2: Congress Is Having a Unique Bipartisan Moment
Another possible explanation for why the market is doing so good in spite of worsening economic outlook is that the stock market is factoring in the quick Congressional response to the crisis. Here, they are not looking at historical data but future data and betting that Congress will act swiftly in the future as it has done in the past. (Wall Street Journal: After Three Coronavirus Stimulus Packages, Congress is Already Prepping Phase Four)
Given that it is an election year, Republicans are feeling the pressure to have the economy return to normalcy as quickly as possible. The challenge is that many of them were highly critical of excessive fiscal stimulus during the last recession. This creates a conundrum for them. If they move forward with quickly passing a stimulus bill, they risk engaging in flagrant violation of their previous position. However, if they do nothing, the economic crisis risks devolving from a severe but short recession to a longer recession, perhaps a depression, or even a double dip recession.
While the last major stimulus bill passed relatively easily, cracks are starting to develop in the bipartisan moment. Given that the Democratic primary is now officially over with Bernie Sander ending his campaign and endorsing Joe Biden, they can shift their focus by going on the offense against the Trump administration and attack him on his strongest asset thus far: the U.S. economy. We saw this recently when the Democrats in Congress essentially rejected a Republican bill outright for not being expansive enough. (Axios: A High-Stakes Clash Over Coronavirus Funding)
If the partisanship in our political system begins to increase, fiscal stimulus legislation will likely get delayed further, increasing the economic fallout. At that point, the news may finally settle into the market and we’ll see it bottoming out.
Reason #3: The Stock Market Rally is Short-Selling
Another possible explanation is that the market ‘rally’ is not a reality at all, but short sellers who are actually expecting the economic data to worsen, Congress not to get it’s act together, and anticipating severe pain, are betting that the market will actually go down further.
It’s something we may have seen already in the spectacular rise and fall of Bitcoin. The theory goes that once short-selling was allowed, we saw a huge increase in the price of Bitcoin. What caused it to go up — it turns out — was investors thinking it was valueless and betting against it. So when they made shorts against Bitcoin, individual investors misinterpreted it as a signal to ‘buy’ and that created the bubble which burst later. (The Wall Street Journal: Is There A Big Short in Bitcoin?)
As the negative data becomes more apparent, the stock market will react accordingly. For example, the unemployment data is already, in some ways, a lagging indicator. But now with so many state unemployment websites crashing or facing severe backlogs, the true unemployment numbers may be obscured for months to come. (Bloomberg: Fired Americans Send Unemployment Websites Crashing Down)
Until the Pandemic is under control, it’s hard to see the economic outlook and the stock market performance with optimism. In order for lockdowns to get lifted and life to return to normal, we’ll need to see the following:
- Contact Tracing: Google and Apple have teamed up to make this a possibility by May (The Verge: Answering the 12 Biggest Questions About Apple and Google’s New Coronavirus Tracking Project)
- Easy, Affordable, Widespread Testing: This could be through antibody testing, COVID19 testing, drive-through testing, etc. Each city and state is dealing with it differently. As a successful model works in one area, it will likely spread to other parts. We’re already seeing regional cooperation in different parts of the country. (Vox: The Case for Ending the COVID19 Pandemic With Mass Testing)
- Scaled Up Healthcare Supplies: With more PPE supplies, ventilators, being developed, it will allow the healthcare system from scaling and not being overwhelmed. Many manufacturers around the country have already shifted their production capabilities to this end. (EHS Today: How Automakers Are Shifting to Produce PPE During COVID-19 to Tackle Safety Issues)
- Vaccines & Treatment: And of course, for total normalcy to occur, the development of a vaccine is necessary (NPR). Until then, solutions like Plasma Therapy (The Washington Post), even some medicine (LiveScience), to treat the disease will also prove helpful.
Many of these solutions are at least 1 month to 1 year away. Around mid-May, we’ll see many states continue to flatten the curve. We’ll see contact tracing launched by Apple and Google. We’ll see ventilators and PPE in mass production. We will likely see local and state governments under immense pressure to loosen restrictions. Thus, best case scenario, much of the economy will be shut down for at least another month. In May, we will start getting a very clear picture of how much damage the economy will have undertaken and we should see how the market reacts then accordingly.