From the time states began to reopen until last week, investors were celebrating the reopening of our economy. Businesses were reopening, consumers started to wear a smile, and Americans gave signs of getting back to something close to what we can call normal. There were even steady medical breakthrough announcements toward both a vaccine and therapeutic improvement in the fight against Covid-19.
The glass was half full.
Last week, however, that all changed. At least that is the message of the market. Yes, America is restarting, but the pace is slow. Restaurant reservations have more than doubled since June 1, but remain almost two-thirds below year ago levels. The percentages will continue to improve over the coming weeks as more states fully reopen. But it is quite clear that more permanent damage has been done than the optimists thought a few weeks ago.
Airline traffic has risen 6-fold since the April abyss. A week ago, the airlines, and airline investors, saw a glimmer of daylight by the end of the year to give hope of survival. But a six-fold increase still leaves traffic counts down over 80% versus last year, and more than 50% of Americans still feel fearful to fly.
The glass is half empty.
Over the past 10 days, the facts really haven’t changed. What has changed is how they are viewed. A half-empty glass and a half-full glass are visually identical. But they are perceived differently. Reported Covid-19 cases are rising as one would expect following the reopening of our economy. Many ignore public health protocols, but that was to be expected as well. While some want the economy to reopen faster, the pace to date has kept hospitalization rates in almost all parts of the country at reasonable levels, and the death rate continues to decline. The fear of a fall surge remains and will remain until it either happens or doesn’t happen. As noted, vaccine progress continues, and it is likely that one or more vaccines with meaningful efficacy will be apparent before the end of 2020, with mass availability roughly around mid-2021. Again, there is no change in that timeline.
The recent anti-racial demonstrations may have elevated fears of more rapid spread, but that isn’t what turned the stock market around. What turned the market around was a combination of bad investor behavior and internal market dynamics that will prove to be an accelerant to every future market correction until structural reforms are put into place.
Let’s start with what I called bad investor behavior. Investors are momentum chasers today. Institutional investors chase momentum, particularly those that trade using computer algorithms. Those are all geared toward following or trying to step in front of momentum. At the retail level, the emergence of Robin Hood and other retail platforms that provide a better mechanism for very small investors to speculate has also fed fuel to an overheated market. Bankruptcies are almost always resolved by wiping out equity holders and splitting whatever net assets remain among the various classes of debt holders. Speculators who buy the equities of bankrupt companies are almost certain to be wiped out in the long run, when the bankruptcy comes to an end. But, as P.T. Barnum has noted, that doesn’t preclude a greater fool from buying your stock at a higher price. People buying stocks of bankrupt companies are taking stupid pills. When a new trucking company with no revenue and no manufacturing plants becomes worth more than Ford, the number one company in pick-up trucks, or Paccar, a leader in heavy-duty trucks, that is another example of excessive exuberance. When those kinds of behaviors run amuck, markets are begging to correct. That started last week. From the March 23 low to the peak early last week, stocks had risen 44% in almost a straight line. The NASDAQ Composite came all the way back to record high ground. It is easy to argue that economic optimism and easy monetary policy support a solid rebound. It may be easy to argue that late-March pessimism was extreme. But setting new highs with an economy that won’t fully recover for years is more than one should have expected.
As for market internals, regulatory authorities have long given in to the power of big institutional money, money that feeds on volume. Technology has rewarded investors who can push themselves in line a nanosecond faster than the rest of us, giving computerized traders an advantage in times of high volatility. In addition, that evil sounding word, derivatives, is reappearing. It isn’t the same derivatives that haunted us during the financial crisis like credit default swaps or collateralized mortgages. This time, it is a combination of options and new securities tied to measurements of volatility. While all derivatives are different, they all share one common characteristic. They leverage the upside and downside opportunities. Buy a stock that goes from $50 to $60, you make 20%. But depending on which option you buy on the same stock, the upside can be many times that gain. Of course, if the stock falls, the investor loses, but the option trader can easily get wiped out. Sophisticated investors buy hundreds or thousands of derivatives; no one mistake is likely to wipe them out. But option spreads feed off of volatility. Sharp market corrections almost always are accompanied by a surge in volatility. At some point, volatility gets so extreme that even the computers can’t react fast enough. Corrections end. But until or unless regulators give markets back to the equity and bond holders and allow derivative investors to dominate, we can expect corrections to be extreme and quick.
But let’s look back over the past two years. There is a ray of sunshine. In February 2018, the stock market fell almost 13% in just six trading days. By the end of April, there was a full recovery. Economically, there were some scares (rising short-term rates and tariffs), but little actually ended up changing. In the fall of 2018, markets collapsed again, this time about 20% in a little over three months. Again, interest rate fears were the culprit. But 2019 saw another recovery that quickly reversed the 2018 losses. In fact, 2019 turned out to be one of the best years in a generation.
This year, awareness of the economic costs of a pandemic sent stocks reeling. They fell about 35% in 5-weeks. But once again, thanks to the accelerant from derivative traders and ETF investors who panicked at the bottom, the March lows created yet another opportunity.
I don’t know where this correction ends. As noted earlier, and as I have written in recent notes, markets seem to have come too far too fast. I have suggested that using fairly conservative assumptions, including continued low interest rates, that a fair value for the stock market by the end of 2021 could be 3300-3400 as measured by the Standard & Poors 500. That is 10-13% higher than it is today, a rate of return over a bit over 18 months that would be in a historic range of normal. But that doesn’t mean the correction is going to end tomorrow. I also note often that, in the short run, emotions always trump facts. Every piece of negative news, every news story that talks of a spike in viruses somewhere, will beget more selling until the sellers exhaust themselves. What I do know, or at least expect, is that any correction will be both vicious and short, and most of the losses will be recovered relatively quickly once the smoke clears, assuming the ensuing facts don’t change the economic picture.
The facts so far remain the same. Every store on Main Street can reopen, but few will return to pre-Covid volumes right away. 20 million Americans unemployed may soon fall back toward 10 million. But they won’t return to the pre-Covid 5 million level any time soon. Many small businesses won’t reopen. Many that do will find insufficient volume to survive and will also close. This is a reality that was obvious two weeks ago. It was ignored then. Now it grabs our attention. A correction can and should be viewed as a buying opportunity, but when the selling is extreme, it is probably smartest to stay out of the way. The time to sell is when euphoria is apparent, as it was when stocks of bankrupt companies were doubling. The time to buy is soon after a selling climax. Some may have felt last Thursday was a climax, but corrections are hardly one-day affairs. The good news is that markets are not wildly overvalued, the Fed is still pumping money in to support markets, and the economy is still improving day-by-day. Covid-19 is still out there, but its economic impact remains within the range of expectations. This correction will end fairly soon, and bargains will reappear.
Today, Neil Patrick Harris is 47. Ice Cube turns 51. Courtney Cox is 56. Xi Jinping is 67.
James M. Meyer, CFA 610-260-2220