Friday, May 8, was a strange day on the markets. That morning, the Bureau of Labor Statistics revealed the damage caused by the blockages linked to COVID-19 in April, and the figures were not very pretty. The unemployment rate soared 10.3 percentage points to 14.7%, as non-farm wages fell 20.5 million during the month.
However, the market rallied, with the S&P 500 up 1.69%, the Nasdaq up 1.58% and the Russell 2000 up 3.64%. So far, the S&P has already risen 33.7% from its March lows, although it remains 13.7% below its February highs.
Given the staggering job losses, what’s going on here? Well, there are several reasons why the stocks have done so well in the past six weeks. While these gains are by no means guaranteed, it is important to note the reasons why scary titles and sharp price movements in the past two months should not deter you from your long-term investment plan.
Reason 1: Job losses: temporary or not?
While the overall employment figures were pretty scary, there was some money in the report. Of those who were laid off, most in the Fed’s investigation actually believe they will only be laid off temporarily. Key phrases: “The number of unemployed workers who said they were temporarily laid off increased tenfold to 18.1 million in April. The number of permanent losers increased by 544,000 to 2.0 million. “
Having 544,000 “permanent” layoffs is much better than having 20.5 million, which could be one of the reasons the market decided to increase despite the numbers. And with many parts of the country starting to relax their stay-at-home rules, investors may feel that these job losses will soon be restored once this happens.
I think he can be optimistic that all job losses will be renewed as demand will continue to be destroyed in many areas of the travel and leisure economy. However, the huge difference between permanent and temporary job losses means that the headline figures may not be as bad as we feared.
Reason 2: the market and share prices are forward-looking
Of course, things are still not great for the economy as a whole, whether the job losses are temporary or not. The gross domestic product of the United States is estimated to have dropped 4.8% in the first quarter, which should lead to much worse results in the second and third quarters, as the first quarter saw only two weeks of foreclosure. In March, real disposable income fell 2% month-over-month and consumer spending fell 6% again. And these are just the numbers for March, reflecting only two weeks of foreclosure. April is bound to be much worse.
This does not bode well for corporate profits this year. Yet it is also possible that all of this bad news was already anticipated by the fastest market fall of 30% in March. After all, the value of a business is the present value of all future cash flows. Thus, if a company’s profits fall to zero but return to normal in a year or two, its intrinsic value is likely to fall only by around 10% to 15% – and even less if the company is an action to high increase. with low current profits and a very long track ahead of him.
Which brings me to the next topic.
Reason # 3: interest rates are lowest
The “present value” of future free cash flow is the discount rate used by investors, which is linked to interest rates. As part of the Federal Reserve’s massive action to support the economy, it lowered the federal funds rate to zero, which serves as a benchmark for many – but by no means all – other interest rates. interest of the economy. A risk-free benchmark that many investors use is the 10-year Treasury bill rate, which has seen its yield drop from 2.45% a year ago to just 0.68% today.
Lower interest rates have the dual effect of stimulating the economy, as well as lowering the “resistance rate” that many investors use in their investments. When investors across the spectrum demand a lower rate of return on assets, asset prices rise, at least on a relative basis. And stocks are just financial assets.
For example, if a security is expected to yield $ 5 in perpetuity, an obstacle rate of 8% would give that security a value of $ 62.50. However, if investors now use a 5% rate, that same revenue stream is now worth $ 100. So the fact that yields on T-bills yield almost nothing makes corporate profits – as spectacular as they are – more attractive. And if certain actions can maintain their profits or even advantage of the home economy, these coveted income streams could be worth even more after the crisis.
Reason # 4: massive government action
In addition to interest rates, one should not overlook the massive action the federal government and the Federal Reserve took in March and April. Congress passed the $ 2.3 trillion CARES law in March, which provided stimulus payments to individuals, subsidies to companies that keep their workers, and low-cost loans to many companies in all sectors as well as of municipalities strongly affected by COVID-19.
However, the Federal Reserve has stimulated even more, buying all kinds of credit products, including treasury bills, asset-backed securities, commercial paper, secured loan obligations (auto, credit card, credit and student loans), corporate bonds, and even some funds traded in high-yield bonds as the crisis worsened. The wave of massive purchases by the Federal Reserve could total more than $ 6 billion injected into the troubled economy, which contradicts the impact of the CARES law.
By declaring itself a buyer of last resort, the Fed managed to put a floor on the credit markets, which enabled many companies to raise liquidity in April to get them out of the crisis.
In addition, this massive and swift action sent the markets a signal that the government was ready to do “whatever it takes” to stimulate the economy and avoid the worst results. This surge of confidence also likely had an effect on the stock market in April.
Reason # 5: Remember the composition of the index
Despite these government actions, many companies and industries remain in a very difficult situation. However, for those who are watching the S&P 500 rise and still scratching their heads, you should note that the top five tech companies are now making up an increasingly large part of this index. In reality, Microsoft (NASDAQ: MSFT), Apple (NASDAQ: AAPL), Amazon.com (NASDAQ: AMZN), Alphabet (NASDAQ: GOOG) (NASDAQ: GOOGL), and Facebook (NASDAQ: FB) combined to represent more than 20% of the S&P 500 at the end of April.
These tech companies all have some of the best balance sheets, business models and growth profiles worldwide, despite COVID-19. And since the S&P 500 is a market capitalization weighted index, as these companies bounce back, they increasingly make up this index, compared to other troubled areas of the market such as airlines or oil and gas, which make up less and less of the index as their values fall. And remember, some of the hardest hit areas of the economy are small neighborhood businesses, which are not included in the index at all.
Thus, the index will average the winners and losers, with the most resilient companies becoming more weighted over time. It also helps the index rebound as the reshuffle between the haves and have-nots of the home economy continues.
Conclusion: is the market right?
While many have been shocked by the decline in markets since the March lows, remember that the initial dip was very deep and rapid. Given the five reasons cited here, it should come as no surprise that the market rebounded against a backdrop of low interest rates, federal stimulus and optimism about the temporary closure of the economy.
However, that doesn’t mean that there still can’t be another lower leg. After all, some of these temporary job losses could become permanent if certain industries remain closed longer. Much will depend on how the economy contains the virus and how quickly biotechnology companies can develop a vaccine. Currently, new treatment candidates are emerging every day, which is fueling optimism. If the containment and treatment are done quickly enough, the market could continue to expand.
However, if vaccine or treatment trials prove disappointing and a second or third wave of virus hits the economy, job losses may continue and GDP may continue to fall, in which case the market may follow these numbers down. As Warren Buffett said at his annual meeting, the range of results is extremely wide.
So what should you do right now? Continue with the investment plan you have set yourself and your risk tolerance. Usually, this involves investing systematically in the market each month, once you have created an emergency fund and paid off your high interest debt. With the market acting like manic-depressive in the past two months, with a shocking drop and perhaps an even more surprising rebound, sticking to your investment plan and getting the emotions out of your strategy is more important than ever.