Quarantine Dispatch

It is a time of tremendous contradiction in the economic world. Stocks and bonds are moving more in tandem than ever. Unemployment is at a high not seen since the Great Depression yet the market is only in correction territory, which means a drop of 10% that happens on average every 12-24 months. The level of personal savings has surged and personal income has increased, but personal spending has fallen drastically. What can account for these disconnects?

Another way to put it is, why on earth is the market doing so well when the economic forecast is so dismal? It could be that health data has leveled off and the vaccine narrative has accelerated so psychological panic has subsided. It could be the short-term effect of trillions of stimulus dollars the Federal Reserve is pumping into the economy to shore up liquidity. It could be that today’s stock market prices accurately reflect the post-Covid economic landscape. It could be the unflagging optimism that is the warp and woof of human nature.

The federal government acted swiftly and massively in their monetary and fiscal stimulus efforts and it made a difference. For now deflation is winning over inflation. The supply chain has not seized up. The Federal Reserve has indicated their willingness to provide more stimulus and Congress is currently negotiating the HEROES Act, which may include more help for state, local, and tribal governments, an extension of unemployment benefits, and more household payments. There seems to be no end in sight for relief as long as the need persists.

We know that the stock market discounts future earnings to yield today’s prices, which means that the recovery is already priced in. The Efficient Markets Hypothesis (EMH), a cornerstone of modern financial theory, states that at any given time stock market prices reflect all available information. The EMH rules out the possibility that investors can time the market or use fundamental or technical analysis to identify securities that are over- or undervalued. However, we know that EMH is inadequate if we consider Warren Buffet’s outperformance of the market over long periods of time.

Investor optimism makes things even rosier. Behavioral finance theory, which addresses the psychology of investors and how their cognitive biases affect stock market outcomes, could help to explain the gap between perception (the stock market) and reality (the economy). Behavioral finance states that investors are not rational or self-controlled and as such make emotional decisions that defy economic theory. We could be seeing hints of Alan Greenspan’s “irrational exuberance” here, although we are far from a speculative bubble.

What happens next? No one has a crystal ball and the best we can do is make educated guesses. Many financial experts predict that the stock market bottom we saw on March 23 will be retested due to increased mobility and a consequent second wave of infections. But that second wave has not yet come. With restrictions lifted across the county, people have been slow to return to past habits. We have not seen appreciable increases in TSA checkpoint travelers, hotel occupancy rates, or dine-in restaurant attendance in locations that have reopened. It is possible – and I am hopeful – that the increased mobility will be mitigated by a beneficial combination of warmer weather, differences in individual susceptibility to infection, social distancing, hygiene practices, and widespread testing and follow up.