October 2, 2020
The collapse of global stock markets back in March this year was more extreme than anything seen before in history.
A financial crash is considered to be catastrophic if it has one Black Monday – this one had two (March 9 and 16) and a Black Thursday (March 12) for good measure.
By the end of March, global indices had lost around one-third of their value, an amount equivalent to many trillions of dollars.
Few could have predicted that just a few short months later, major markets would be recording fresh all-time highs.
The benchmark American index, the S&P 500, set a new record on September 2, closing at 3580.84. The NASDAQ Composite set a new all- time high on the same day, closing at 12,056.44.
The Dow Jones Industrial Average didn’t break the record it set on February 12 (29,551.42), but came within touching distance, closing at 29,100.50.
This is all particularly surprising when you observe the chaos unfolding in the real economy.
US GDP shrank by a staggering 31.7 per cent in the second quarter of 2020, the largest quarter- on-quarter contraction in history and more than three times the previous all-time decline.
The US unemployment rate also quadrupled in April to 14.7 per cent – the highest level since records began – before falling back to a still very high 8.4 per cent in August.
A surface-level analysis of this would say that American stock markets are fundamentally out of kilter with the depleted American economy.
But this doesn’t tell the whole story and indeed, James Kyle, investment director at Rathbones, believes that markets have in fact responded rationally to what’s been happening over the last six or seven months.
“You’ve got to look at the underlying components of a particular market or index,” he explains. “When you look at something like the S&P 500, it’s incredibly varied how individual companies have performed.”
The S&P 500 is home to technology companies like Microsoft, Amazon, Apple, Facebook and Alphabet Inc (Google), each of which has been well-positioned to benefit from the changes to ways of working and living ushered in by the pandemic.
James adds: “When Amazon reported their second-quarter figures, their sales had increased by 40 per cent compared to the year before.”
The bullish performance of America’s tech giants goes a long way towards explaining the rapid recovery of its financial markets. These companies are now the largest in the world and make up more than a fifth of the S&P 500’s total value.
Conversely, if you look at the performance of S&P-listed companies in the travel, retail, leisure and hospitality sectors, these stocks have been decimated.
“They’ve had really, really bad share price moves,” James agrees.
But this almost doesn’t make a difference to the headline index because of the outperformance of tech companies.
James believes a K-shaped recovery is therefore most likely – one where technology, healthcare and consumer goods companies continue to produce record results while travel, retail and hospitality firms continue to fail.
Another point to consider is the degree to which Government and central bank intervention has driven the stock market recovery.
The unprecedented sums of money we’ve seen pumped into the financial system have ensured there is sufficient liquidity in the markets and that companies have remained solvent.
It’s also driven interest rates near zero and massively expanded the market for government bonds (treasuries and gilts).
James explains: “The bond market is much bigger than the stock market on a global basis and when governments manufacture the return you’ll get from lending them money by cutting interest rates, that means those assets are much less attractive for investors to hold.
“If investors aren’t getting a real return in the bond market anymore, naturally, their money will find its way into stock markets because there’s more potential for capital growth.”
If the so-called search for yield is another driver of the stock market recovery, then so is the growth of retail investors putting money into stocks and shares.
Online trading platforms like Trading 212, eToro and Robin Hood have democratised access to the markets by giving DIY investors the opportunity to invest without having to pay broker fees and other costs.
James says: “There’s been a vast amount of retail money going into stocks because millions and millions of DIY investors are now dabbling in the stock market and that wasn’t the case previously.”
Taken together, the outperformance of big tech companies, the search for yield outside of the bond market and the rise of DIY investors helps us to understand why American markets appear to be so detached from the realities of the American economy.
Time will tell whether higher unemployment and lower economic output will drive markets back into correction territory or whether their impressive run will continue.
If one thing’s clear, it’s that volatility will continue to reign supreme.