The stock market is forward-looking. In order to understand why it’s up, it’s important to examine forward-looking leading indexes — rather than indicators like gross domestic product (GDP) or the jobless rate — to validate the market’s rise. Such leading indexes will include many non-market related indicators, like building permits and initial claims for unemployment insurance.
In every recession since World War II, the S&P 500 has turned up a few months ahead of the business cycle trough. In light of this historical pattern, coupled with the sequential upturns in our leading indexes, it’s logical that the S&P 500 would turn up when it did, in late March.
A forward-looking stock market should begin to recover when the economy is in bad shape and still worsening.
Certainly, the Fed has helped to bolster securities prices, especially by backstopping the credit markets and by driving interest rates down. But valuation — while certainly relevant to long-term returns — is a poor guide to the timing of cyclical turns in stock prices.
In the epicenter of the pandemic, this was the first real sense that the Covid-19 curve was beginning to bend, and the market began to see a light at the end of the recessionary tunnel.
Looking ahead through the summer and fall, however, the recovery could follow two very dissimilar, yet familiar, trajectories, with different implications for stock market risk. If the recovery continues apace, we could see something akin to the 2009-2010 scenario, where stock prices kept rising despite widespread skepticism about economic prospects.
But a fresh slowdown in economic growth soon appeared on the horizon. Stock prices turned down in January 2002, and by October had fallen well below their September 2001 lows, possibly because the extreme overvaluation in the dot-com boom hadn’t been entirely wrung out in the post-9/11 plunge.
Some version of the 2001-2003 scenario is a significant risk today should the nascent recovery lose steam. If infections spread rapidly from the protests or political rallies — or if a second wave of the pandemic threatens later this year — and fear of the virus drives people to disengage from normal commerce once again, we could see another significant downturn. Separately, since the job losses in this recession are concentrated in the service sector, where revivals in jobs tend to be slower than in manufacturing, there’s a danger that — following the initial snapback due to the reopening of the economy — job growth will ease, or even falter.
So far, things are still pointing up. But with an unusual amount of crosscurrents at play, things could swiftly change. We’re keeping our guard up.