In recent weeks, as stocks have rebounded strongly from their March lows, many have asked if the market has come too far, too fast. Thursday’s sharp selloff may have been an expression of that concern.

However, the answer to that question, like pretty much all questions of valuation, boils down to an assessment of expected return and risk. As we have argued before in recent months, there are good reasons for a positive view on expected return. 

• First, the sectors of the economy that have been most badly affected by the pandemic are not the most important sectors to the stock market.
• Second, this should be a bookended recession—starting with a virus and hopefully ending with a vaccine. If earnings can set new, all-time highs in 2022, then given the long-term nature of the cash flows implicitly embedded into stock prices, equities should not be marked down too much to account for weakness this year and next.
• Finally, aggressive action by the Fed and other central banks have pushed interest rates to unattractively low levels, leaving investors with few alternatives to stocks.

However, when it comes to risk, the current pricing of equities does suggest complacency. After all, stocks are supposed to hate uncertainty and 2020 is yielding a bumper crop of it. 

While the greatest danger to markets usually lies in events no one predicted, there are plenty of plausible risks that are worth reviewing, including the following six possibilities:

1. The pandemic sees a “second wave.”
2. A safe and effective vaccine isn’t produced in a timely manner.
3. Congress fails to pass further coronavirus relief this summer.
4. A messy election produces a contested result.
5. Taxes and interest rates rise in the aftermath of the election and pandemic, or,
6. Over-easy fiscal and monetary policy triggers a financial crisis within a few years.

Second Wave
Page 26 of our Guide to the Markets illustrates both the natural infectiousness of COVID-19 and the success of social distancing. In just six weeks, from early March to mid-April, the U.S. went from a handful of daily infections and no deaths to over 30,000 confirmed cases and more than 2,000 deaths per day. Since then, social distancing has not only flattened the curve but reduced it, with the pandemic’s toll easing to just over 20,000 daily cases and 800 daily deaths in the last week.  

However, as states partially reopen their economies and as many skip elementary precautions, (such as wearing a mask when social distancing isn’t possible), the decline in cases appears to be stalling. This suggests that the disease could reaccelerate in the months ahead, particularly when colder weather reduces outdoor activities and many schools and colleges reopen.  

If this happens, regardless of government regulations, many Americans will revert to hunkering down, squashing a tentative revival in the industries hardest hit by social distancing such travel, entertainment, restaurants and traditional retailing.

Vaccine Disappointment 
A second risk is that current efforts to develop, manufacture and distribute a safe and effective vaccine fall short. There are, of course, many ways these efforts could fail. Despite multiple different efforts around the world, scientists may fail to produce a safe and effective vaccine. Or it could be that the vaccine provides limited immunity or immunity only for a short period of time. The government could also fail to develop an infrastructure to immunize the entire population or a large percentage of the population may refuse to be vaccinated.

Even in this scenario, normal life should resume in time. As the population wearies of social distancing, a certain herd immunity would develop over time anyway, although at a very heavy human cost. More hopefully, better drugs to treat the symptoms of the disease should become more widely available, reducing both deaths and the severity of infections. However, without a vaccine, full economic recovery would undoubtedly be delayed, with obviously negative implications for the financial well-being of individuals, companies and governments.

Political Gridlock
A third risk concerns the damage that could be done to the economy between now and the distribution of a vaccine and this damage could easily be made worse by a political standoff. With serious negotiations on a new relief package delayed until the second half of July, Democrats and Republicans remain divided over issues of unemployment benefits, state and local government aid, incentives to help workers return to the job and the vulnerability of companies to pandemic-related law suits. 

While these are all serious issues, with state and local governments already implementing cutbacks and enhanced unemployment benefits set to expire at the end of July, a political standoff that extended into the fall could result in a slower and more painful recovery.

Election Chaos
A further political risk is the potential for chaos surrounding the November elections. Part of this, of course, springs from a very deep political divide in America in 2020. However, in addition, polling problems so far this year in a number of states have highlighted the additional difficulties caused by the pandemic, as millions of Americans will likely try to vote by absentee ballot. Unless one side or the other wins by a very decisive margin, this could easily degenerate into accusations of fraudulent or rigged elections. Even if this is resolved, any unrest or uncertainty caused by election chaos could further undermine an economic rebound.

Higher Taxes And Interest Rates In A Recovery
Finally, there is the matter of a fiscal and monetary reckoning after the election and once the pandemic finally subsides. Assuming that Congress passes a further $2 trillion in federal pandemic relief over the 12 months, we estimate that the federal debt will swell to 114% of GDP by the end of the next fiscal year in September 2021. This would far exceed even the debt-to-GDP ratio after the end of World War II. At the same time, if the Federal Reserve continues to buy Treasuries at the current pace of roughly $80 billion per month, its total holdings of federal debt would exceed $5 trillion, in a balance sheet that had grown to over $8 trillion.

How these issues are tackled may well depend on the outcome of the November election. In a Democratic sweep, the new Administration might feel pressure to reduce the federal deficit while simultaneously increasing spending on health care and infrastructure. This would likely mean higher taxes on wealthier individuals and corporations, both of which would negatively impact real, after-tax returns. 

In addition, under the new Administration, the Federal Reserve could well take the opportunity to reassert its independence, and, once the economy is on a strong recovery path, it could taper its purchases of Treasuries and begin to raise short-term rates, with potentially negative consequences for stocks.  

Long-Term Fiscal And Financial Meltdown
However, an alternative, longer-term risk to investors could result from a continuation of current very easy fiscal and monetary policy. If, following a Republican sweep, the Administration and Congress refuse to countenance tax increases while simultaneously pursuing higher infrastructure spending, federal debt would likely grow more quickly. If the President replaced the Fed Chairman and other Fed governors with people he regarded as more loyal, monetary policy could remain more expansionary for longer. 

However, such a path could eventually result in a fiscal and monetary meltdown. As modern monetary theorists are fond of pointing out, a sovereign government with a captive central bank can never be forced to default on its own bonds for the simple reason that it has a ready buyer with unlimited powers to print money. 

However, while investors can be sure of being fully paid back in dollars, they could lose confidence in the dollar itself, and higher inflation, along with dollar devaluation could be the result. Such an inflation could only be ended by very painful fiscal and monetary actions to restore trust in the value of the currency. A lesson learned in the U.S in the 1970s and 1980s and in many emerging market countries since then is that, once you have forfeited trust in your currency, you have to run a much tighter monetary and fiscal ship to regain it.

It is, of course, possible that the U.S. will avoid all of these dangers. However, investors should bear them in mind when considering strategy today. Many may be relieved that the stock market is holding up so well in this otherwise dismal year. However, investors should be clear-eyed about these risks, suggesting a somewhat more diversified and defensive stance until events can hopefully dispense with at least some of these more negative outcomes.

David Kelly is chief global strategist at JPMorgan Funds.