The market sell-off is an overdue correction, says Bruderman Brothers’ Oliver Pursche, after U.S. markets marked their biggest fall in seven years. Aleksandra Michalska reports.
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Unemployment is soaring. Corporate earnings are shrinking. And we’re almost certainly in a recession. So why has the stock market — which was down 34% at its bear market low on March 23 — been able to trim a large chunk of its losses even though the economic news remains gloomy?
Simply put: investors are forward-looking, and they are buying in advance of — and in a belief in — better days ahead. That’s one explanation for the market’s 25% rebound rally in the past month.
It’s confounding at times to grasp that concept, especially when things are grim in real-time.
History confirms this future-oriented investor behavior. Since 1953, with one exception, the Standard & Poor’s 500 stock index has bottomed (or hit a low) anywhere from three to 11 months prior to the end of a recession, according to Strategas Research Partners data. On average, the market troughed four months prior to the end of an economic contraction. Stocks rose nearly 25%, on average, from the market low to the end of the recession.
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Stocks, of course, are priced on expectations of publicly traded companies’ future profit streams. So, investors care less about yesterday and more about the post-crisis era and what’s to come in the next six, 12 or even 20 months. When news for companies and their workers is bad and, as a result, stock prices have taken a big haircut, it’s usually a good investment bet to assume both the news and business conditions can only get better.
Jason Brady, CEO of Thornburg Investment Management, sums up the disconnect between negative headlines and positive stock price action: “If prices try to take into account the end of the world, and the end of the world is slightly less likely to happen, equities can rise.”
So, that’s point number one. Stocks rise and fall on how things turn out relative to expectations.
The second thing to keep in mind is that when pricing in future business conditions, investors at first focus on any signs — even small ones — of change. They’re willing to buy on any shred of evidence of emerging “green shoots,” or early signs of improvement. They don’t need to see GDP pivot from -5% to +1%, or first-time unemployment claims go from 6.6 million per week to 250,000, before they buy.
“Markets tend to focus more on change in speed, versus change in direction,” Brady says.
To illustrate that point, he adds: “When markets began to turn around in 2002 and 2009, we observed that the economy was contracting less slowly, with a degree of confidence that at some point in the future it would begin to expand again.”
So, that’s point number two. Stocks start to rise when data suggest things are getting less bad. Things don’t have to be great. If you wait to buy long after the tough times are over, you’ll likely miss the rebound.
Inflection points matter, too.
The so-called smart money is always trying to identify turning points, or subtle changes in data or other metrics they’re watching, that suggest a coming rebound in corporate earnings. New inventions, interest rate cuts from the Federal Reserve, government relief programs, or stocks going up on bad news are examples of inflection points.
“Investors look for inflection points,” says Olivier Sarfati, head of equities at wealth management firm GenTrust. “Often, though not always, investors … do a good job at forecasting long-term prospects. This is why the market starts pricing the recovery before it is fully visible.
“For example, in 2009,” he says, “U.S. stocks started going up on March 10, 2009, even though the peak in unemployment was two weeks later. The market had just seen green shoots and started pricing in positive results from the recapitalization of the banks.”
There are even stocks that are expected to lose money for five years, Sarfati explains, “that are still priced based on the fact that they will make money later on.”
So point three is this: Stocks often take off when inflection points spell opportunity.
There’s one caveat, though. The market’s early reads on improving conditions can prove in hindsight to be premature, notes Thornburg’s Brady.
“Stocks don’t always indicate economic direction without plenty of false starts in either an up or down direction,” Brady says. “Economists sometimes joke that the equity market will predict 10 of the next three recessions.”
Remember, market head fakes are a possibility.
“Wouldn’t it be interesting if after the rally we are currently witnessing, stocks were to go back down in the third quarter as … demand for products and services appear to be impaired for longer than previously thought?” says GenTrust’s Sarfati.
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