In a year replete with unprecedented and unfathomable developments, one of the most remarkable is the resilience of the equity market in the face of a global pandemic and the sharpest economic contraction in history. As the extent of the COVID-19 crisis and the economic cost of the effort to constrain its spread became evident, stocks panicked into the unknown from late February into March, dropping 34% in 23 trading days. And then the market turned on a dime. Starting on March 24, the S&P 500 rallied close to 18% in just three days, and then kept on going straight up. Even as death tolls and historically awful economic news continued to mount, stocks moved higher and higher, closing last Friday 32% up from the lows of late March. The S&P 500 is now higher than it was at this point in 2019 and down just 7.8% since the beginning of the year. How can this be? How can the stock market seemingly ignore the very real health and economic challenges that this nation still faces and be so disconnected with reality?
History provides the outline of an answer. Financial markets are discounting mechanisms: The value of any asset – be it stocks, bonds, real estate or art – is simply the net present value of all the future cash flows that the asset is expected to provide, whether dividends, coupon payments, rental income or the ultimate sale of the asset at the end of the holding period. The value of an asset depends, therefore, not so much on today’s market environment, but on what investors expect the future environment to be, and the interest rate at which those future expectations are discounted. Although headlines remain troubling at present, investors are looking forward to a future in which continued progress on the healthcare front allows economies to return to some semblance of normality. By the time these positive developments dominate the news cycle, the market will be far down the road to recovery.
Thus it has always been. Although the catalyst of the 2008-09 global financial crisis was rooted in finance instead of biology, the psychology of forward expectations played out as it always has. The S&P 500 bottomed at 676.53 on March 9, 2009, and rose sharply even as the economic crisis continued. The recession did not end until the summer of 2009, by which point equities were 37% higher. The labor market continued to deteriorate, and unemployment didn’t peak until November 2009, when the stock market was up 63% from the trough. By early 2010, it started to become evident that the job market had decidedly begun to recover and that the worst of the financial crisis had passed. Once this good news made it into headlines, a new bull market was a year old and 71% underway.