Where Do US Stocks Go From Here?

Were US stocks in a so-called “Bubble” before getting slapped down by COVID-19?

Bubbles in asset valuations tend to follow a similar pattern. They start small and fly under the radar with a few smart investors taking early positions. More attention and enthusiasm follows as the asset value gains momentum. Then investor greed takes over and folks begin chasing the asset. Next, it’s all the public can talk about in the mania stage, even creating new narratives (“This is no bubble—it’s different this time”). Finally, you get a blow-off top and crash. Wash, rinse, repeat.

The triggers, players, and extremes are always different, but the general pattern is the same because it’s the story of human behavior. Economies, investments, technologies, the times they all change, but people as a group do not. 

Dr. Jean-Paul Rodrigue of Hofstra University created this great chart illustrating the Stages of a Valuation Bubble. Used with permission.

We could write pages on each stage of human behavior, but I find especially interesting the reflexive rally (“Bull Trap” to the “Return to Normal”) that typically follows the blow-off top. It’s kind of like a head fake. More investors get sucked into thinking it’s safe to get back in the water. “Whew, glad that’s over!” but then the rude awakening of more downside to come. 

History is littered with such financial bubbles, from Tulipmania in Holland in the 1630s down through the centuries. More recently, in 2000-2002 the dot com and technology stock bubble cratered the Nasdaq stock index nearly 77%. During the Great Financial Crisis of 2007-2009, it was mortgages, real estate, and ultimately a crashing of stock markets, with the S&P500 stock index down around 57% at one point.  

In my view, the 2009-2020 extended bull market (pre COVID) and extended valuations reached in stocks, bonds, and real estate resulted in kind of an “Everything Bubble.” On the whole, it didn’t feel like a ga-ga mania as in 2000-2002 or 2007-2009 mind you, but still extreme. 

So the big question: Are we currently riding the stages of a typical valuation bubble or did COVID-19 put us on a different path entirely?  

Are we currently in that reflexive rally stage just before hitting another stock market ski slope and/or a long grind downward?

Nobody knows, of course.  

There’s no intelligent debate that US stocks have been on the overvalued side for years. Clearly, some of that’s been supported by economic growth, tax cuts, and solid corporate profits, but also on the flipside by central bank monetary policy on steroids, corporate borrowing at low interest rates to buy back their stock, and just the general optimism and animal spirits of the market. 

In a real sense, markets have been “overdue” for a healthy cleansing for an extended time. Global growth was already slowing in fits and starts. COVID-19 was simply the spark that lit the fire this time around. 

But a significant difference this time vs. the usual bubble pattern is that global response to COVID-19 has been to put ourselves into an economic coma. In other words, with the shut-downs we did this to ourselves. On purpose. And that changes the game and the expectations, I think. 

• Over 20 million jobs lost so far in the US, with that likely to increase.
• Nearly 15% unemployment (US) so far, and by some measures it’s much higher.
• More than 30% (annualized) decline projected for the US economy in 2020-Q2, depending on which economic shop you consult.
• Tens of thousands of small businesses in the US unlikely to survive the shutdown due to financial devastation, irrecoverable staffing loss, or change in customer behavior once things reopen.

So then looking at this one-year chart of the S&P500 stock index, how is it that the stock market has already recovered most of the February-March 2020 crash? 

It’s helpful to remember that the stock market and the economy are not the same thing. They’re more like cousins or maybe stepsisters. It’s rare that they synchronize in the short term.

And it seems the collective market is looking through to the other side of COVID-19 (whenever that is) and assuming it’ll be business-as-usual with a quick V-shaped economic recovery. 

Could a V-shaped economic recovery happen that justifies the V-shaped stock market recovery so far? Sure. 

Is it likely? Given the economic destruction from shut-down and the uncertainty surrounding COVID-19, I’d give it a low probability. Like maybe a snowball’s chance in hell.

But even if we don’t get a V-shaped recovery, the extreme fiscal and monetary intervention—by the US as well as other global governments—may have moved the goal posts vs. the kind of decline we might otherwise expect. It’s entirely possible the self-induced economic coma plus pulling out all the stops financially could keep the stock market plates spinning. Especially if “everybody knows that everybody knows” that government has taken over and it’s no longer a real market of natural prices.

This is uncharted territory and nobody has all the answers. History is helpful for patterns and context but investment prudence is the order of the day.

If stress in the financial markets is causing you concern about your portfolio or broader financial picture, feel free to reach out.

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