Is the Market Running on Irrational Hope?

With coronavirus cases rising, unemployment at historic levels, and ongoing protests across America, the strong market rebound feels like it could be driven by irrational hope. Are the markets assuming there is an effective vaccine by the fall? Are they ignoring the effects of a worldwide 100-year pandemic that has killed over 650,000 people as of July 30th?

While there are certainly times when markets can behave irrationally, such times are few and far between and usually concentrated in a certain asset class or sector. At this point, with the exception of the FAANG stocks (Facebook, Apple, Amazon, Netflix, and Google), we do not see signs that the global equity markets are acting irrationally. It is important to distinguish that this belief does not mean that the market might not experience another significant downturn.

Market prices represent the aggregate predictions of thousands of professional and individual investors regarding the value of the company’s future earnings plus the book value of its assets. The operative words here are prediction and future. The stock markets typically bottom when investors have the most fear and have the bleakest outlook on the future. Historically, bottoms have typically coincided with the point of peak unemployment. A rise in the stock market does not mean that the recession is over or that it might not continue for several more years. It simply means that investors are anticipating a better future down the road.

For example, according to Charles Schwab’s analysis of data from Refinitiv, the market consensus estimates for S&P 500 companies for Q3 2020 is a -23.5% drop from the previous year. That does not seem very optimistic to me. Ned Davis and Charles Schwab recently showed that historically the S&P 500 has performed best when year-over-year earnings growth was between -20% and 5%. It seems very counterintuitive that stocks would be rising when earnings growth is negative, but again, markets are predicting the future, not what is happening at present.

Many of you are probably still wondering or worried about the market going down from here. As the future is uncertain, the answer is, unfortunately, yes, the market could go down from here. But that does not mean you should pull all your money out.

Ironically, your risk of losing money in the markets today is less than it was in January. Markets account for uncertainty by keeping prices below fair value. The difference between true fair value and the market price is the compensation investors receive for taking risk. In times of perceived low uncertainty, market prices are close to fair value and investors get little compensation for taking risk. As the pandemic has taught us, risk is always with us whether we see it coming or not. Currently, because of the high degree of uncertainty, market prices incorporate more downside risk, and investors who stay in the market are getting higher compensation for taking that risk. Taking risk is a necessary part of investing, but as investors, one of the most important things we can do for long-term success is to ensure that we are being appropriately compensated for those risks. Staying in markets when we receive high compensation for taking risk is a key part.

I would love to have a crystal ball that could tell you how the market is going to move tomorrow or next month or next year. It seems very possible that the economic recovery could slow, and the market could go sideways or take another dip. It also seems very possible that through a combination of growing knowledge, human adaptation, and government stimulus, the economic impact will not be as severe as some fear, and the market will continue its steady climb. A wide variety of data suggests that current market valuations are not irrational and that markets are appropriately accounting for the high degree of uncertainty surrounding the trajectory of the economic recovery that will ultimately occur. There are plenty of investors who are pulling money out or who are continuing to sit on the sidelines as well as plenty of buyers. Our recommendation is to continue with your target equity allocation. This approach allows you to benefit from the relatively high compensation you are getting for taking on risk right now while providing sufficient downside protection that your financial well-being is not at risk.

Disclosure: Past performance is no guarantee of future results. No client should assume that future performance of any securities, asset classes, or strategy will be profitable, or equal to the previous described performance. The S&P 500 is a market capitalization-weighted index of 500 widely held stocks often used as a proxy for the U.S stock market.