Markets are forward looking in that stocks will respond more to the direction of the economy than the level of the economy.
There’s a growing consensus that the economy is in the process of bottoming. For market participants, that means navigating a barrage of conflicting commentary and analysis. Some would advise investors to focus on the level activity while others on the direction of activity. Be wary of taking sides in this debate, because both might be correct. Economists at Goldman Sachs Group Inc. and Morgan Stanley see evidence that the economy will trough this quarter and then resume growth in the second half of the year. The underlying logic is straightforward. Activity across the globe was brought to a standstill to slow the spread of Covid-19. Now we are slowly opening the economy, and a trickle of activity is evident. The trickle will grow into a steadier flow as we keep opening more parts of the economy.
One implication of such a forecast is that equity prices have also reached a bottom for this cycle, helping explain the rebound in major stock indexes. Markets are forward looking in that stocks will respond more to the direction of the economy than the level of the economy. Once you see the economy hit bottom, you have to start looking toward the future. And by definition of “bottom,” the future looks brighter than today.
This implication will elicit howls of protest in the vein of “stock valuations can’t be justified given the level of economic activity.” We’ve heard that in the wake of the last recession. The problem with this protest is that stocks entered a solid bull market in the last decade despite persistently high unemployment and low output relative to potential. It was the direction of the economy that was important for stock prices, not the level.
Even if we accept the hypothesis that the economy and equities have bottomed, it’s not all smooth sailing from here. Plenty of risks to the outlook that pose ongoing threats to equities remain. The first and most obvious is slow growth. The economy might pop in the early stages of the recovery only to limp along thereafter. There are significant dislocations that will take time to heal. Employees have become detached from employers; many firms will go under and need to be rebuilt. Social distancing restrictions will keep large portions of the economy in the dark.
The second risk is a resurgence of the Covid-19 infections. The Trump administration is pushing to reopen the economy even if it accelerates the pace of infections. Even if these restrictions are lifted, consumers won’t venture out in droves unless they are confident they can do so safely. Opening too early risks renewed closures in the future, wasting all the effort to support the economy during the first round of closures.
The third risk is fiscal fatigue. The economy won’t bounce back quickly and needs additional support to minimize second and third round impacts. If employment doesn’t rebound quickly, enhanced unemployment benefits will need to be extended to keep supporting households. State and local governments still need the same help getting to the other side of the virus in the form of the same cash transfers provided to firms and households. But such aid might be delayed, especially if Washington becomes overly confident in the economic outlook once activity stabilizes.
The upshot is that you don’t have to own exclusively one side of the story. Stocks might have bottomed along with the economy. They may be at valuations that are high relative to earnings if prices are responding to future growth. If so, it is reasonable to expect the odds are weighted toward future gains in the medium term, which is the optimistic scenario I lean toward.
But nothing about this means that stocks aren’t still vulnerable in the near term. A bottoming in growth rates does not mean the economy will quickly return to its pre-virus levels. It doesn’t preclude a policy failure. It doesn’t mean stock prices will rise rapidly. And it doesn’t preclude a retest of the lows.
You don’t have to be a bull or a bear. There is plenty of middle ground between the two.