2020 has been a remarkable year that continues to surprise us. On the one hand, the stock market records and its apparent recovery have been unusually swift.  However, the economy has been in and remains in dismal shape. This downturn occurred due to the coronavirus, which became a significant threat in our country in February 2020, posing profound implications for public health and our economy.

Does a V-shaped recovery in the stock market signal a V-shaped economic recovery where a recession could be brief? Recent market action is saying it is highly possible, supported by some positive economic news. Bureau of Labor Statistics (BLS) released an unemployment rate for May at 13.3%, better than the expected 20% rate.

Not So Fast…A BLS Correction Still Shows An Improvement

Unexpectedly, the BLS  admitted to misclassifying furloughed workers. They can be forgiven for this error as there are nearly 5 million people are in this category. That is a far more significant number because of the pandemic’s impact.

As a result, May’s unemployment rate is now closer to 16.3%. Also, April’s unemployment rate, previously 14.7%, would be revised to a 19.2% rate on an apples-to-apples comparison. That means May’s unemployment was still an improvement in April’s pace, justifying the stock market’s recent positive reaction. No question, there are still way too many people who are unemployed.

 

Relationship Between The Stock Market And Our Economy

Stocks move on news that conveys information related to the economy. Generally, the relationship between the stock market and our economy often converge and depart from each other. Gross domestic product, unemployment, inflation, and many other indicators reflect economic conditions.

As a leading economic indicator, the S&P 500 composite index represents the market proxy, is often predictive of a recession or economic recovery. The S&P index captures stock movements, along with the widely known Dow Jones Industrials, and NASDAQ composite index.

A rising stock market may indicate favorable economic conditions for firms, resulting in higher profitability. On the other hand, a declining stock market may signal an economic downturn. Over the long term, these trends are likely to show the economy and stocks in tandem. Day-to-day, those correlations may be harder to see.

Stock Market Turbulence During The Pandemic

After the S& P 500 index peaked at $3,386.15 on February 19th, the market bottomed on March 23rd at $2,237.40. This swift 33.9% decline marked the transition from a longstanding bull market to a bear market. Market volatility in that one-month timeframe was unprecedented. There were 18 market jumps greater than 2.5% in 22 trading days (February 24 to March 24).

That was not all to record-setting stock price movements as sudden as the S&P 500 index was its rally back to $3,193.93 on June 5th close. The substantial rise in stocks has responded to our economy’s opening as lockdowns ease, and people return to work. That is an astounding 42.8% climb through the latest close. The market is nearly back to the February 19th peak.

Bear Market Rally Or A New Bull Market

A question that keeps coming up: are we experiencing a bear market rally or a new bull market? We wrote about the difference between a bear market,  bear market rally, and bull market here. Generally, a bull market occurs when there is a rise of 20% or more in a broad market index over at least two months. Investopedia defines a bull market as when stock prices rise by 20% after two declines of 20% each.

Let’s leave aside the bull market definitions. We have been facing a time of extremes with the coronavirus’s impact on our markets, economy, lockdowns, and lives. When the markets initially plunged, we suggested that investors consider not selling stocks in panic unless they needed to do so for liquidity purposes. Having an emergency fund is essential providing liquidity so that you cover your living expenses during unforeseen events. I think we can agree that the coronavirus was such an event. We pointed to the Great Recession as a recent example of why you should avoid selling stocks at a market bottom.

How Far Can Stocks Rise? It Depends

With some early signs of economic improvement, do the stocks continue to rise? That depends on whether there will be future upside surprises to indicators that matter. Yes, the revised unemployment rate of 16.3% is a better number than the nearly 20% expected. The initial 13.3% rate (now adjusted) caused a positive surprise that had stocks soaring. After this climb, stocks may retrench a bit.

Let’s face the fact that even if the 13.3%  unemployment was correct, it is still a high number, well above the 10% peak of the Great Recession. To some extent, there were more liberal unemployment filings associated due to COVID-19. People who were part-timers, had hours reduced, or lost work-study income were allowed to file unemployment benefits. If people go back to work as quickly as they lost their jobs, that would be great news.

The continued rise in stocks will be dependent on how fast and far unemployment rates decline. According to the BLS report, those on temporary layoff included in the jobless numbers in the first wave of job losses (or 15 million), may be recalled to work. People are going back to work in phases. Whether unemployment rates continue to come down depends on whether we have more job cuts or the second wave of coronavirus infections as some fear.

3 Factors That Affect Stock Prices

Typically, a company’s value should reflect the present value of its future cash flows. Investors should consider several factors that affect whether the stock is overvalued or undervalued to calculate future cash flows. There are three key fundamental factors that affect stock prices.

1. The Economy

Investors look at how economic growth drives demand for the company’s products and services: the more substantial the need, the stronger the company’s revenue, cash flows, and potential valuation. When investing, you should have a basic knowledge of the economy and the Fed’s role in correcting economic changes. Those changes could indicate a weakening economy, direction of interest rates, or higher inflation. We believe that understanding why unemployment matters, which you can read here.

The severity of the coronavirus and government action encouraged social distancing and lockdowns. As a result, there were alarming changes in economic indicators, signaling a recession. With a low 3.5% unemployment in February, our economy was healthy, then rose to 14.7% in April. Weekly initial claims for unemployment insurance and its four-week moving averages tend to be a better economic gauge. They rose as we experienced the virus’s impact on our lives. Jobless numbers started to grow in the hundreds of thousands by late February, then to millions of people in March. Even now, the unemployed levels are still rising at high rates, though they improved from the initial claims in March and April.

From the start, this economic decline was different from previous recessions. Our economy’s downturn was event-driven by a coronavirus, but that doesn’t make it any less devastating. Economic activity ceased as many remained sequestered at home.  When unemployment rises, consumers spend less, and businesses suffer. Layoffs and furloughs resulted, mostly if workers could not work remotely. Essential workers were feverishly needed to do jobs despite the threat of the virus. They weren’t shopping either.

High Personal Savings Rates

Rather than spending, personal savings rates rose to a record level of 33% in April. That’s another indicator that consumers were hoarding cash out of fear or reduced consumption as we stayed home. That’s a good news-bad news story. Personal savings are essential to build as an emergency cushion, reduce high debt levels, or invest in assets. Americans had been lagging in savings rates for years. However, those rates have been improving to 8.2% in February. Ultimately, that cash will result in pent-up demand and consumer spending.

What Stocks Reflect

How quickly will our economy recover? The recent unemployment numbers may indicate that a V-recovery is possible. I think it is too early to tell as more good data is needed.  Stocks respond quickly to news that either reward or punish investors. The S&P rose 2.62% for the latest trading day (up 5.6% for the week) reacted to revised information. Investors have seemed to be optimistic. Market sentiment is a measure of the general mood of investors in the stock market. As stocks rise, the market may give back some of the gains if there is no further favorable news to support the stocks’ higher valuations.

Stock valuations reflect expectations in the future. However, existing poor economic conditions do not always negatively impact stock market performance. You can make money in the market, even in a weak or recessionary environment, based on optimistic expectations. Stocks rose during the Great Recession as they have during the past two months. A firm’s stock may be affected by its industry’s conditions or its relative strength.

2. Industry-Related Matters

Specific industries and their stocks–airlines, automotive, energy hotels, brick & mortar retail, restaurants-swiftly bore the brunt of the market decline due to the coronavirus impact. On the other hand, other industries benefited from the stay-at-home lockdown measures. Those were online businesses, notably leaders in e-commerce, telemedicine, video conferencing providers, and those with potential vaccines or testing equipment. Many investors made changes to their portfolios. They sold specific stocks they anticipated would be most hurt by the lockdown, rotating into the newer winners. I made some of those changes to my portfolio. Additionally, as the market seemed riskier, I bought more dividend-bearing stocks of companies with strong balance sheets.

What Industry Do You Want To Invest In

Generally, industry factors matter when picking stocks for your portfolio. What makes an investible industry? It may depend on what you are seeking.  If you are seeking growth, technology could be a profitable sector. Look at some of the various subsectors, such as cloud companies, very much in demand. On the other hand, if you are looking for stability, consumer staples (e.g., Colgate Palmolive) that produce and sell everyday necessities may be the right answer.

You want to look at industries that may have dominant companies that can ward off competition in a profitable sector. On the other hand, avoid sectors that may be subject to new regulations that hurt margins.  Once you decide on an industry you want exposure to, look at the best companies in that group. Investors compare relevant price to earnings valuation of a stock compared to its peers based on its competitive advantages, margins, market share, and management. Sometimes stocks or their industry may be in an infancy stage of development and may not necessarily generate earnings yet. Then, in that case, investors use other valuation metrics such as a multiple of revenue or cash flow

3. Company-Specific Aspects

The stock you are buying or selling will be based on your knowledge of that company’s relevant factors and its valuations. Investors look at specific expectations for growth in revenues, cash flow and earnings, balance sheet strength (e.g. liquidity and debt ratios), and corresponding valuation. To consider a company’s strength,  look at some of the personal financial ratios relevant for investing.

Positive earnings surprises may send a stock soaring, while a negative earnings surprise may prompt a stock to decline. Investors like to see mergers, acquisitions, and divestitures that may benefit one or both companies as they fill a void in their business portfolio or raise capital from a sale.

Investment Biases Affect Decisions

Volatile markets and economies impact our emotions. The more turbulent the market the greater the likelihood we may be affected by our biases. Generally, we make investment decisions by relying on fundamental analysis to determine if a security is undervalued. If the stock market is efficient, it means that the stock prices are rationally priced, fully reflecting all available information. As investors, we try to capitalize on any discrepancies on a particular stock or new report not already accounted for to profit on that position.

Sometimes stock may be mispriced because of the psychology involved in decision-making known as “behavioral finance.” This discipline can offer behavioral/emotional or cognitive biases to explain why markets or stocks are moving in a certain way. Learning about these biases can help us to shift away from these tendencies away and invest more wisely.

Having biases–cognitive and emotional– may cloud our judgment when making investment decisions. Since the coronavirus pandemic, we have changed many of our consumer habits to protect ourselves from exposure. We have quarantined ourselves to practice social distancing, buying products in bulk, and shopping online. Now we are slowly reversing ourselves as we come out of lockdowns. Be aware of some of the common biases we use when investing, which you can read here.

Final Thoughts

This year has been extraordinary, and we are only in June. The coronavirus has caused public health and an economic crisis challenging to deal with. Although the economy is far from recovery, there have been opportunities to make money in the financial markets. While the market has been turbulent, the S& P 500 is not far away from the February peak. Whether the V-shaped recovery in stocks will become a V-shaped economic recovery remains to be seen. High unemployment levels will take time to improve to normal levels as people return to work. I remain cautiously optimistic about a recovery but worry that stocks may be trading ahead of themselves.

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