The Upside of the Stock Market is Limited

Introduction

With a surge in COVID-19 cases across pockets of the US, and the Chair of the Federal Reserve forecasting a sluggish economic rebound, the stock market tumbled this week, potentially signaling that it’s starting to come to terms with the economic reality currently unfolding across the world. But is this a sign of more to come? I’d like to argue that it is and that stock market’s upside is limited. To make my case, I’ll first argue that the market was beginning to look frothy, making it prone to another sell-off, and secondly, the COVID-19 crisis, which is showing no signs of abating, will continue be a significant headwind for the stock market.

A piece of news that really struck me this week was Hertz seeing a massive surge in its stock price. On May 24th, the day it filed for bankruptcy, Hertz opened at a low of 41 cents. Fast forward to June 9th, it opened at $4.78, a 1065 percent increase! A financially healthy company making that sort of leap is astounding, but that kind of performance from a company that had just filed for bankruptcy defies any kind of rational thought. Think about it: Money is actually being invested into a company that cannot pay its debts and whose stock has cratered in the past five years. This will not end well.

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Hertz’s stock price over the past five years

Of course, it’s possible that this strange behavior is confined to just Hertz, but something like this has been unfolding in the overall stock market since late March. Since that time, The S&P 500 had rallied approximately 45 percent, prior to its tumble, despite the onslaught of horrible news, including the unemployment rate sky-rocketing into the mid-teens, multiple industries being on the verge of collapse, and the sky high death toll and confirmed cases of COVID-19 in the world’s largest economy. A stock market rally of over 30 percent in good times is somewhat out of the ordinary. In bad times, it’s mind boggling. How does one make sense of this?

Two common explanations are that the monetary-fiscal stimulus and the re-opening of the US economy will continue to power the market. I find neither convincing.

I’ll start with the stimulus argument. Over the past several months, trillions of dollars in stimulus have been injected into the economy to keep it afloat. Businesses have been able to procure vital loans to see them through these tough times, and the Federal Reserve has pledged to take extraordinary action by buying distressed debt and keeping financial markets functioning. With such extraordinary actions, the thinking goes that companies and the economy will not fail, minimizing the risk towards investors.

The problem with this argument is that it ignores the economic fundamentals. Sure, companies may be able to get through this intact, but this does nothing to make up for the demand shock that they are experiencing right now, making them considerably less healthy financially, and therefore a less attractive investment.

Of course, with the country starting to re-open, demand might start to pick back up, leading to a rebound in companies’ finances and prospects. However, such a scenario can only happen if the virus is brought under control, and unfortunately it is showing no signs of abating:

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The number of new COVID-19 cases per day. Courtesy of the NYT COVID-19 database (https://raw.githubusercontent.com/nytimes/covid-19-data/master/us.csv)

While the number of confirmed cases per day has declined since its peak in late April, the number has been stuck in a holding pattern since May. Since May, the average number of new cases is 22,621, and with the country continuing to reopen, I would not expect this number to significantly decline. In fact, the number might surge, leading to another shutdown, most likely. Either way, the lasting presence of COVID will most likely prompt people to continue to halt economic activity, leading to reduced demand, causing companies to pull back on investments and hiring, therefore muting the economic recovery.

Stimulus and optimism can only take the stock market so far. There comes a time when actual revenue will have to start coming through the door, and that can only happen when the specter of COVID-19 is no longer hanging over us. But since it still looms large, the horizon remains cloudy.

Disclaimer: This is not intended as investment advice, and the views in this article are solely my own.

Stumbled into a data-centric role several years ago and have not looked back! Passionate about leveraging technology to uncover answers and improve the world.

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