Even as we absorb the impact of the coronavirus on our lives and the economy, the financial markets have begun to look ahead to what the world will be like after the pandemic. The S&P 500 is now up +28% from its March 23 low and is only down -12% in 2020. This results in odd juxtapositions, with headlines simultaneously tallying the worst shocks of a major recession while stocks post significant gains. But that’s not unusual. Quite the contrary—it’s to be expected.
What drives the fair value of a stock or of the market overall? The cash flows that a company can generate from now until forever1. In fact, for any company you choose, almost all of the stock’s value today comes from the cash flows it will generate in 2021 and beyond (Display 1). Even with a recession causing a fall in the company’s current and future cash flow trajectory, that creates an anchor to which any given stock and even the market as a whole will be tethered.
While startling in its speed and magnitude, the recent sell-off we saw is understandable. In a matter of weeks, the market had to adapt to a world in which not only was the future path clearly worse than before, but the potential downside risks were much worse than most people could have imagined months earlier. As the market began to incorporate that, Wall Street earnings estimates for 2020 and 2021 fell swiftly (Display 2).
And although we’re not out of the woods yet, the fundamental picture has finally begun to improve relative to what it could have been. It may not seem like it, with tens of thousands of people dying and over 30 million people suddenly unemployed in the span of around a month. The human and social toll of this crisis has been unreal, to the point of being almost unimaginably painful. But even as the world fell apart, the single most important event in March was that health officials and policymakers finally shut down enough of the economy to begin containing the virus.
That has begun to slow the growth of the virus around the world. Since the virus drives everything else, it was a critical first step toward improvement.
The Bridge to Better Days
From here, investors have finally begun to build a bridge to the other side of the pandemic. This bridge is based on several key pillars:
- Health policy (noted above)
- Fiscal policy
- Monetary policy
Throughout much of the US, policymakers finally showed that they were serious about containing the pandemic.
In addition to public health policies, the US Congress and other global governments took swift and decisive action, launching several major spending programs to help struggling businesses and individuals. This was the single largest and fastest fiscal response to an economic shock that the world has ever seen (Display 3). While some damage to the economy is inevitable, the government made clear that they will step in to lend support and, perhaps most importantly, be willing to intervene further if necessary.
Along similar lines, the Federal Reserve and other global central banks took aggressive action to ease financial conditions and maintain liquidity for investors and companies. Even more than Congress, they made clear that they will do pretty much whatever it takes to keep the economy intact.
Neither fiscal policy nor monetary policy can end the pandemic or allow daily life and the economy to return to normal. But the market is already anticipating that normalization to some extent. Many of its hopes rest on improved and expanded testing—not only testing to see who has the virus so they can self-isolate or receive treatment, but even more importantly, antibody testing to see who has already had the virus and hopefully has immunity that will allow them to return to normal life. Once containment efforts have worked, widespread testing will be critical in allowing the US and global economies to rebound.
Ultimately, life will return to normal when we have a long-lasting vaccine for COVID-19. Much like the vaccines we’re used to for other diseases, this will allow us to once again live without fear. However, for that, we’ll have to wait until 2021 at the earliest, meaning we’ll have to compromise in one way or another for some time to come.
It’s impossible to know how long a testing-based approach will be required before a real solution is in place. As a result, it’s also impossible to say for sure how long the negative economic shock will last or how deep it could be. To deal with this uncertainty, our economics team thinks primarily in scenarios. Their base case is that the economy will begin to rebound later in 2020 and return to its previous rates of growth in 2021, while losing some output permanently due to trips that won’t be taken, products that won’t be needed, and services which won’t be used in 2020.
The Path Ahead
The more the market can look past the horrific headlines and begin to gain certainty around what the world will look like in 2021 and beyond, the more stocks will recover (Display 4).
At times, the market may get ahead of itself. It could become overly optimistic about policy responses and underestimate the length and severity of the recession. Or it could become overly pessimistic as the economy worsens, as companies face bankruptcy, and as US consumer health fades. Above-average stock market volatility is perhaps the only certainty as we look ahead.
But that volatility could create breaks for investors to take advantage of. The seeds of long-term investment performance are sown in downturns. In recent weeks, we’ve seen a number of attractive opportunities emerge.
Recessions tend to be drawn out over many months. While the market has rebounded sharply from its recent lows, the recession has barely begun. As the shockwaves ripple through the economy and markets, we expect to see continued opportunities for long-term investors in the weeks and months ahead. Eventually, another bull market and economic expansion will begin. Investors who stay invested and take risk when the market is paying a premium for it should be able to reap the benefits.
1Of course, most companies are sold or go out of business well before forever arrives.
- Matthew D. Palazzolo
- Senior Investment Strategist—National Director, Investment Insights
- Christopher Brigham
- Senior Research Analyst—Investment Strategy Group