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Monday, June 14, 2021
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To many observers, the disparity between the performance of the stock market and the performance of the U.S. economy is a classic case of cognitive dissonance. Investors fully understand the seriousness of the pandemic and its effect on the economy. And yet the stock market is partying as if the pandemic has been contained. As the S&P 500 index sets new all-time highs, the economy is just beginning to improve from a historic downturn in the wake of the outbreak of COVID-19. The U.S. gross domestic product (GDP) contracted by 31.7% in the second quarter and the domestic unemployment rate remains in double-digit territory. While the stock market historically rallies ahead of an economic recovery, the magnitude and the velocity of the rally is unprecedented. What could explain this unusual phenomenon?

Flashback to 1992

Sometimes the answer to a seemingly difficult question is more obvious than initially thought. As the contentious presidential election draws closer, I harken back to the 1992 presidential race. George H.W. Bush’s reputation was lifted from the successful winding down of the Gulf War. His approval rating soaring above 90%. (Can you imagine that happening again?) But domestically, the U.S. had slipped into a recession. Arkansas Governor Bill Clinton joined the presidential campaign, focused on domestic economic policies that could help lift the economy. His chief advisor, James Carville, was the architect of Clinton’s campaign strategy. His messaging was famously trumpeted with the slogan “It’s the economy, stupid.” While Bush tried to parlay his foreign policy success into another four-year term, the Clinton camp focused solely on the economy. Carville knew that during a struggling economy, voters tend to vote with their pockets.

Getting back to the question at hand, we would like to proffer a construct for the stock market surge in the face of the current economic malaise. Piggybacking on Carville’s famous quip, we believe the answer is rather simple: “It’s the Federal Reserve, Stupid!” To understand the surge in the stock market, one must look at the forceful actions taken by the Federal Reserve beginning in late March.

Prior to the COVID-19 pandemic, the President Donald Trump referred to Federal Reserve Chairman Jay Powell as an “enemy.”

“My only question is, who is our bigger enemy, Jay Powell or Chairman Xi?” Trump tweeted.

Twitter – @realDonaldTrump – August 23, 2019

While Powell and the Federal Reserve did not fold in the face of harsh criticism from the White House, they eventually changed course when the financial markets and the economy began to crater. The Fed embarked on aggressive monetary stimulus in unprecedented ways. On March 15, 2020, the Fed cut the overnight Federal Funds rate to 0%. The Fed also embarked on several powerful rounds of quantitative easing, purchasing trillions of dollars of fixed income securities.

But how does easy money drive higher stock prices during a historic economic downturn? In past economic cycles, it took many months – and years – for the stock market to recover.

How Low Interest Rates Drive Investor Behavior

With the massive quantitative easing, investors have become more anxious about how to generate income on their investments. The traditional safe havens such as Treasury Bills and CDs have seen their yields drop to near zero. The Federal Reserve’s aggressive bond purchases have also made longer term fixed income securities less attractive. With many stocks still paying reasonably attractive dividends, the stock market has become one of the few places to satisfy the appetite of income-hungry investors. In many cases, dividend yields on stocks are exceeding the yield on high quality bonds by a growing margin.

Hedging Against Inflation

Inflation is surely not on the minds of most investors these days. But even if inflation stays in the current 1-2% range for years, investors are concerned that by sticking with safe Treasury securities, they are guaranteeing a loss of buying power. We are currently living in a world characterized by negative real returns as the inflation rate is running higher than the yield on most Treasury securities. Thus, investors are increasingly incentivized to invest in assets where there is a potential for generating positive real returns.

Low Interest Rates as an Elixir For Technology Stocks

One sector that has been a substantial beneficiary of the shift into stocks has been the technology sector, which has been outperforming the stock market for a number of years. Many technology companies have some of the strongest potential growth profiles in this economy. Moreover, the rapid spread of the pandemic has led to a substantial transformation to a “stay-at-home” working environment. This reset has been driving a massive investment in technology goods and services.

But easy money and near-zero interest rates is also proving beneficial for technology stock valuations. Stocks of companies that experience rapid growth can also benefit from falling interest rates. This is because a higher proportion of their earnings are expected well into the future. Because low interest rates decrease the opportunity cost for waiting for those returns, investors are more comfortable waiting for the long-term payoff.

Too Much Money Looking for a Home

There are other potential drivers for the strong rally in stock prices. But I would argue that most of those drivers are in some way related to monetary stimulus. The sheer size of the stimulus causes more and more cash to seep into the stock market. When the Fed increasingly injects money into the financial system, the excess cash is forced to find a home in a host of asset classes. We have seen this effect not only in the stock market but also in disparate asset classes such as gold, cryptocurrency and private equity.

This Time Is Different?

One could argue that this monetary phenomenon can be deemed a growing asset bubble. For now, the Federal Reserve “giveth.” But, what happens when the Federal Reserve eventually “taketh away?”

In 1933, legendary investment guru John Templeton published a book called “16 Rules for Investment Success.” One of those rules was that historical market patterns tend to repeat over time. Templeton said, “The investor who says, ‘This time is different,’ when it’s virtually a repeat of an earlier situation, has uttered the four most costly words in the annals of investing.”

At the risk of contradicting Templeton, I will suggest that this time may be different. Going into the pandemic, interest rates were historically low, which propelled stock prices to elevated valuations. But with the added monetary stimulus, the Federal Reserve has made equity investing even more compelling.

What Is the End Game?

This time may be different in the near term. Longer term, Templeton’s words could once again prove true. Much will depend on the path of the economic recovery and the timing of the eradication of this virus. But there are probable scenarios that we believe should be considered. In coming articles, we will examine what we believe those scenarios could be.

Jonathan D. Caplan, a former Wall Street executive, is president and founder of wealth management firm, Caplan Capital Management, Inc. with offices in Highland Park and Hackensack. He holds a BA from Yeshiva University and an MBA in Finance from New York University Stern School of Business. You can find other recent investment articles by Jonathan at www.caplancapital.com/blog.

The views presented are those of the authors and should not be construed as personal investment advice or a solicitation to purchase or sell securities referenced in this market commentary. The authors or clients may own stock or sectors discussed. All economic and performance information is historical and not indicative of future results. Any investment involves risk. You should not assume that any discussion or information provided here serves as the receipt of, or as a substitute for, personalized investment advice. All information is obtained from sources believed to be reliable. However, we do not guarantee the accuracy, adequacy or completeness of any information and are not responsible for any errors or omissions or from the results obtained from the use of such information.

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