MARKET PARADOX - Today's market contradiction
The biggest question for U.S. financial markets nowadays, it is how to reconcile the spectacular recovery rally on stocks under the worst set of economic reports ever published.
We are not alone in this quest. There is a stark polarization in this subject among investors. Mostly, bulls and bears agree that the long term U.S. economic future is bright. Still, they do differ in the short term financial situation and the appropriate assets values for stock and bond markets.
The two key variables for market supporters (bulls) and detractors (bears) are time and money. The length of time to wait for science for a permanent health solution, and the amount of money central bank is willing to contribute to keep economies afloat while we wait for that scientific solution.
The narrative of the bullish camp is supported on two pillars, first, the virtually unlimited money the Federal Reserve and U.S. Government is printing and distributing to support the whole economy will be enough to wait for a permanent health solution. Second, the belief that a vaccine or an effective treatment for coronavirus will be discovered quickly. The economy as a whole, as they expect, will bounce back fast, and that it is why market are so high today.
The arguments for the bearish camp believes, first, the Fed will not provide money forever, even if they can, to every company that requires it because it will create bigger debt problems in the future. Second, they do not believe there is a quick resolution to this pandemic. They believe this situation detonated structural damages we already had, creating economic scars which may only be healed after a wave of debt restructuring and bankruptcies.
The clock is ticking, the past is catching up with us, economic reports for the last months the next quarter reports show the depth of the impact, but we were all expecting terrible results.
The global avalanche of positive news about vaccines and treatments keep the markets hopes high. Leading government are funding every effort for a vaccine and treatment. The problem is not certainly about money, it is just about time and science.
So far this year after March lows, the U.S. stock market (i.e., S&P 500 index) is about -11% down since the beginning of this year. It has found a stable band of support between 2800 and 2930 levels.
Most pessimistic will argue the whole economic situation might deserve a lower price for stock markets. I know it is strange, but the stock market and the economy are related but not the same. This might be surprising and counter-intuitive.
Stock market indexes represent a sample of the largest and public companies, valued at their market capitalization. This market value is what investors decided these companies' future cash flows are worth today, based on forecasts profits.
While when we see the gross domestic product (GDP) of the economies, oversimplifying, we are looking at the sales value of the whole economy products and sales reported in the recent past. Comparing the market value of the biggest companies with the past sales of all companies have significant differences.
Like everything in nature and life, there is always a Pareto contrast, where a small group of big corporations accumulated a disproportionate bulk of the economic profits and employed less labor force.
In contrast, a large group of smaller and private companies who have the majority of the labor force and sales has a smaller share of the profits, and financial markets are not the exception. As an example, more than 40% of the GDP is linked to small companies.
Digging deeper into the components of the U.S. market index, we may find other differences to the whole economy. The U.S. stock market index (S&P 500) is composed mostly of big companies, and biased towards technology and healthcare-related sectors.
Roughly more than 50% of this stock market index (S&P 500) value is within these two sectors. On top of the above reasons, this pandemic has shown us that technology is essential to work, educate, and interact, and not just a fad.
This U.S. stock market technology biased might also partially explain the sharp over performance in the last decade against other world stock indexes, such as European and Asian indexes.
Reviewing the performance of the components of this recent rise in the U.S. stock market index, we observe that while technology, health care, and consumer products goods companies have recovered most of their losses year to date, the rest of the sector are still struggling.
Up to this point, we may see why there is a reasonable explanation for the divergence between the U.S. stock markets and the main economy. But there is an additional question, why is the difference so massive?
This is where the vast uncertainty about the economic future creates the most significant differences between those who justify current stock market levels and those who do not.
For those who see a rosy future, today, the rewards are more significant than the risks, and likewise, for the others who see more significant risks than rewards, current market price levels are excessive.
It is a fact without saying that market psychology has a more significant effect on markets than on the economic indicators. We shall see if current prices are driven by short term optimism or an accurate interpretation of the risks and reward balance.
Who is right? We do not know yet. But life and investing long term is more about gray shades than black and white. Now financial markets are always forward-looking. The recent past makes investors uneasy, but the hope of light in the future makes them greedy. I believe more than ever; it is essential to be selective and give more weight to the quality and sustainability of profits than wild bets.
This binary situation is where we stand today. All the government money printing bought time to wait for a better tomorrow, but is that tomorrow as good as investors imagine? And are current asset prices adjusted to that likely future scenario?. Those are the never-ending questions we face once more.
Curious enough, although it is about the future, we as an investor can only extract insights and cues from the past, make decisions in the present, and contrast with future outcomes. The financial markets as a whole, with its uninterrupted supply and demand balance, will measure if our decisions were right or wrong.
The matter of fact is that most market forecasts are not useful. The assessment of the balance of market risks and potential rewards and the level of risk you accept are the biggest keys to invest.
These investment tasks are not easy. And we all have to face the fact nobody has a perfect batting average all the time. Just try to have the more winners than looser bets over time, and you will have succeeded.
If you want your investments to achieve your goals, you are not required to seek and accept huge risks, as some people think, it is the opposite, you must agree to a reasonable level of risks when the odds are in your favor. Of course, knowing if the risks and odds favor you is the core of this game.
We have to hope we set an investment strategy according to our risks that provide us with the best batting average over time.