Ed Peters
July 10, 2020

Stock markets advanced in volatile trading in the second quarter, regaining much of the losses from the Q1 sell-off. Sentiment shifted frequently based upon the news of the day. With few companies offering forward guidance (only 20% of the S&P 500, for instance), investors have had to deal with increased levels of uncertainty on their own. The question for investors is whether the rally is real or just “the mother of all dead cat bounces?”

When faced with high levels of uncertainty people often have a tendency to fill in the blanks and make what little they do know fit a story rather than wait for more information. While perfectly rational, when decisions are made under time pressure, this level of uncertainty is also a prime breeding ground for the type of rationalization that leads to poor long-term decisions. It is possible that the market has fallen victim to this way of thinking.

To begin with, the stock market priced in gradual economic reopening as if economic conditions would quickly return to the “before time,” when no one had heard of COVID-19. Consumers would resume going to restaurants and large events with confidence and businesses would resume investment as if the past several months have all been a bad dream. Unfortunately, there is little evidence of either occurring. For instance, there was a surge in restaurant reservations after reopening in May. But Open Table shows reservations quickly reached a plateau at a fraction of the “before time” rate. So what justifies the market rebound? Generally the advance has been viewed as a natural result of liquidity generated central bank policies and fiscal stimulus in the form of loans. Is such activity sustainable, or is this merely a rationalization to explain a market advance no one understands? That is the question.  

The response to economic news shows a similar level of rationalization. The economic decline brought on by the Great Lockdown is slowing, but conditions continue to deteriorate. For instance, the employment situation has improved, but the number of unemployed remains at levels not seen since the Great Depression. Manufacturing and services are still contracting but at a slower rate, according to Markit. Yet, these dire bits of economic information are being taken as evidence of an economic recovery. There is a significant difference between a “recovery” and a slower rate of decline. A recovery would mean that the economy is resuming growth. But clearly that is not what is happening. 

Finally, at the end of the second quarter, COVID-19 infections began to re-accelerate and many reopening policies were paused or reversed. The market has been mostly ignoring the bad news on combating the virus, while advancing on economic news interpreted as evidence of a “recovery.” But economic data is lagged, while COVID-19 information is closer to real time. Clearly, the stock market is reacting more to lagged economic data than real time COVID-19 information. Why? Perhaps economic data is the devil they know and COVID-19 data is hard to extrapolate. So better to give pandemic news a lower weight in decisions, even if it is closer to real time information. 

This tendency to accentuate the positive and downplay the negative is a danger sign. Lacking guidance on earnings and working in a highly uncertain economic environment, market participants are creating their own story to explain market events to fit the few facts they know. Perhaps the market is right, and we will return to the “before time” by the New Year. But it would be prudent to remain skeptical.

Past results are not indicative of future investment results. Commodities trading involves substantial risk of loss.
© First Quadrant, L.P. 2020. Intended for Institutional and Qualified Eligible Persons Use Only. The views expressed are the views of First Quadrant, L.P. only as of the date shown and are subject to change without notice based on market and other conditions. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice, recommendation, or solicitation of any particular security, strategy or investment product. This publication has been prepared without taking into account your objectives, financial situation or needs. Before acting on this information, you should consider its appropriateness having regard to your objectives, financial situation or needs. It is your responsibility to be aware of and observe the applicable laws and regulations of your country of domicile. All material has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

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