It’s hard to believe, but in just more than a month, U.S. stocks, as measured by the Dow Jones Industrial Average, a widely followed albeit partial and imperfect proxy, have gone from a record high to the fastest correction in history to the best week since 1938. Driving these moves to a great extent were the contrasting investor sentiments of complacency at first and then panic. If you can correctly characterize the week’s strong rally, you hold the key to what lies ahead.
The Dow hit its record on Feb. 12 despite mounting evidence that the coronavirus was already damaging the global economy. China’s economy, the world’s second largest, had been brought to a virtual standstill. Global supply lines had been disrupted, causing some factories elsewhere to close. International trade was falling. And the source of all this, the highly contagious Covid-19 virus, was already spreading to other countries.
Some of us had been warning for weeks about the threat of the coronavirus because it inflicted “cascading economic sudden stops”, which are common in fragile and failing states but not in systemically important economies. They are highly disruptive because they destroy both demand and supply at the same time. As such, this was an urgent and complex policy priority that did not provide a “buy-the-dip” opportunity for investors.
These warnings fell largely on deaf ears, and for understandable reasons. The sudden stop dynamics, while extremely consequential, were largely unfamiliar to the vast majority of economists and policy makers. Similarly for Wall Street analysts, investors and traders who — conditioned by years of ample and predictable liquidity provided by central banks and amplified by the “fear of missing out”— had developed an almost automatic response to buy any market pullback regardless of the cause. This combination had evolved into a seemingly can’t-miss approach as central banks’ ability to repress financial volatility and shield elevated asset prices from more sluggish corporate and economic fundamentals drove stocks from one record to another.
But as the coronavirus devastated more of the Asian economies, paralyzed northern Italy and was reported in several other European countries, the evidence became overwhelming that this was indeed different. Company after company reported blows to actual and future profits as revenues shrank, costs increased and even people and inventory management became much more difficult. With the United States also threatened, there was no denying that this was now a serious economic shock that would have financial consequences — the first two stages of the four-stage process I detailed a month ago.
Not only did the price of stocks and other risk assets fall, but they did so in an increasingly disorderly fashion. Having overpromised liquidity to end users for years, a phenomenon facilitated by the spread of ETFs and other products that provide easier access to usually hard-to-reach market segments, the system could not accommodate all those now wishing to rush for safety and cash. And the more investors and fund managers were unable to sell what they wanted to sell, the more they disposed of whatever they could. This spreading contagion caused indiscriminate carnage and threatened the very functioning of some markets. With that came the possibility of an accelerated financial deleveraging which, combined with what was happening on the economic front, threatened both a 1930s-like depression and a 2008-like global financial crisis.
The fast, sharp and particularly disorderly market correction served as a loud wake-up call for policy makers. The result was a historic “all in,” “whatever-it-takes” and “whole of government” approach in country after country. In the U.S., this included huge Federal Reserve policy interventions and a $2 trillion fiscal relief package.
With the prospects of both a global depression and financial crisis averted for now — a sudden and deep recession is, unfortunately, already a done deal — stock prices bounced sharply and the Dow climbed during the week, even with Friday’s 4% drop. But the message of this sharp move up is subject to intense debate in the marketplace.
The optimists see it as the start of a process to form a bottom that promises further gains after this year’s harrowing losses; the Dow is down 24% year-to-date. Supporting their argument is growing evidence of better market functioning in key segments such as Treasuries and investment-grade bonds.
The pessimists see it as a counter-trend rally, or what is more popularly called a “dead cat bounce.” They point to several similar instances during the September 2008-March 2009 sharp market downfall.