On February 19, 2020, the S&P 500 closed at a record high. It then dropped by 34% over the next five weeks.
That loss did not surprise me. By late February 2020, Japan had announced that it would close its schools for the following four weeks. Shortly thereafter, the Italian government locked down one fourth of the country. Clearly, those stoppages were merely the beginning of the economic problems; the rest of the developed world would soon follow suit. Such shutdowns would cause financial carnage.
Economists then were talking mostly about second-quarter effects, but I thought that the damage would linger. The global economy would not return to full strength for many months, if not years. What’s more, I knew that over the past century, the S&P 500 had declined by more than 30% on five occasions, without once reaching its previous high within the next 18 months. Sure, stocks would eventually rebound - they always do - but surely the process would be halting.
At best, I figured, US equities would bounce about their March lows. At worst, they would fall further. Either way, the next bull market wouldn’t arrive anytime soon. Those with faith in their hearts and cash in their wallets need not rush to invest. There would be plenty of opportunity to buy stocks at their new, lower prices. Of this I was as certain as I have ever been about the investment markets.
Reality Intrudes
Never had I been so confident in my stock-market expectations - and rarely had I been so wrong. The S&P 500 immediately staged a powerful rally, surpassing its previous high by August, then adding another 15% during the ensuring six months. Not only had I not envisioned such an event, I had not even imagined it.
The problem wasn’t with what I knew. My economic forecast was correct. As I had expected, although third- and fourth-quarter gross domestic product rebounded from second-quarter levels, they remained below that of the first quarter. The destruction wrought by Covid-19 on both economic output and employment exceeded that which had been forecast in March. Neither was my stock market history faulty. The numbers were accurate.
But for other reasons, this time was different. During previous bear markets, stocks would rally briefly, then retreat as sellers appeared, seeking to profit from the temporarily higher prices. Two steps forward, one step back. In 2020, though, the optimists overwhelmed the pessimists. Rapidly, investors worried not about being caught by the market’s retreat, but instead forgoing its gains.
Why Equities Recovered
The market’s resilience owed to three primary causes, each of which I had considered. But I had not realised their full implications.
1) Structural Strength
Demand shocks, such as that caused by the Covid-19 virus, shove teetering economies over the edge. If the system is wobbly, because corporations are overinvested, or consumers heavily indebted, or banks poorly capitalised, then the shock reverberates. The effect spreads far beyond its original impact.
Such was not the case in 2020. Although the economy was in its 11th year of expansion, companies were not extended, because they had cut back on their capital investments. Neither were consumers. Adjusted for inflation, mortgage debt was well below its 2007 peak, and delinquency rates on other forms of consumer debt had declined. Finally, banks had greatly improved their balance sheets since the global financial crisis.
This isn’t, of course, to deny that tens of millions of households have suffered from Covid-19-related slowdowns. However, those problems have not caused systemic failures. Few large companies have been forced to declare bankruptcy, and the banks remain solvent.
2) Federal Intervention
The US government’s response to slumping stock prices was swift and powerful. The Federal Reserve promptly slashed short-term interest rates to just above zero, while announcing that it would purchase an unprecedented variety of investments. Meanwhile, Congress passed the $2.2 trillion CARES Act. With each financial crisis, the government intervenes ever more aggressively.
Whether such intercessions courted future disaster, by suggesting to equity investors that federal officials would inevitably rescue them, has beenhotlydebated. What isn’t up for question are those actions’ immediate effects. By flooding money into the system, the government raised stock-market demand, and thus succeeded in its attempt to support equity prices.
3) Weak Competition
Low interest rates stimulate spending economic activity, but they wouldn’t much help stock prices if bond yields were steep. Last March, the dividend yield on S&P 500 stocks hit 2.3% - modestly above recent averages, which have hovered near 2%, but not attractive by historical standards. However, with yields on 10-year Treasuries dropping as low as 0.60%, that dividend payout was relatively high.
Quietly, 10-year yields have doubled since that time, while those of 30-year bonds have climbed above 2%. With the stock-dividend rate shrinking due to market gains, the income from holding equities now roughly matches that of investing in Treasuries. So far, stocks have resisted the challenge from rising bond yields, but if fixed-income yields keep increasing, they eventually will buckle.
Predictions and Insights
Last spring, I realised that almost nobody can successfully forecast the direction of the stock market. Over the years, I had seen enough market-timers and tactical allocators fail to appreciate the enormity of the task. I also recognised that economists have enough difficulty estimating the next quarter’s GDP growth, never mind what will occur in 12 months’ time.
Yet, despite my experience, I deceived myself into believing that I possessed special insight. That happened because the market behaved as I expected during the early days of the Covid-19 crisis, thereby leading me to overestimate my abilities. It mattered not if I understood the problem relatively well. To make an accurate prediction - one that would benefit an investment - my understanding needed to be deeper yet.
Thinking through market conditions is a useful exercise. Better to suffer investment losses that were at least partially anticipated than to have them come as a complete surprise. Beware, however, the danger of taking such analysis too seriously. My self-belief was greater than my insights. In making that mistake, I am far from alone.
