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.