Contrasting the stock market’s incredible run in the second quarter to the lack of developments of the same magnitude in the fundamental economy warrants a question as to whether the stock market is getting ahead of itself. Although this is certainly a major risk to consider and has been on the minds of investors, there are possible explanations that may justify the swift rise of the market, as well as potential risks to be mindful of from where we stand today.

Actions by the Fed to keep interest rates low and providing ample liquidity through its balance sheet expansion while maintaining transparency of its action is an environment supportive of risk-bearing assets. The intention of the Fed to keep rates lower for longer especially in an environment that lacks inflation results in lower expected volatility that lends well to a “hunt for yield” environment. Given the relative attractiveness of stocks to bonds at current interest rate levels fueled by higher dividend yields relative to bond yields, appreciation potential from the reinvestment of undistributed profits, and a more attractive risk premium could incentivize investors to favor equities in their portfolios. Such demand has the potential to increase valuations until the relative attractiveness of stocks dissipates.

Additionally, the market seems to be more concerned about the rate of improvement than the level of improvements in the economy. Figure 1.2 below illustrates an example of such development. Although the level of initial jobless claims is much higher than in previous recessions, the rate of improvement we are seeing from the continuous decline in weekly jobless claims throughout the second quarter is certainly positive despite the cumulative level of claims increasing. Fundamental improvements in the economy ranging from the labor market to manufacturing activity have improved since the lockdown began and have been mainly supported by massive fiscal stimulus that helped keep the households and businesses afloat. The notion that part of the existing fiscal stimulus package have expiration dates and are coming due create anxiety over whether households and businesses can remain solvent. However, as we noted earlier, the thought of a deterrent government seems improbable should conditions fail to improve, and we would expect the Treasury department to initiate another round of stimulus if necessary.

Figure 1.2

Finally, as markets look forward to future corporate earnings prospects, discounting future earnings growth at today’s low rates may also justify higher current valuation that was evident in the Q2 market performance. In our view, corporate earnings are unlikely to return to pre-crisis levels until late 2021 or early 2022 but the long-term corporate earnings growth trend remains intact. The current crisis is unlikely to permanently reduce aggregate corporate earnings below its historical norms because the economy continues to be diverse and innovative. Market leadership may have changed due to the crisis in favor of technology firms, but long-term corporate earnings are expected to recover beyond pre-coronavirus levels at some point in the future.

Figure 1.3

Nonetheless, markets have indeed moved very fast and very far, which warrant a greater deal of caution and skepticism. An abundant of risks remain with regard to another uncontrolled outbreak, increasing geopolitical tensions with China, volatility prior to a Presidential election, increased debt levels for both corporations and governments, near-term impact to profit margins, elevated absolute valuations, and other potential hidden vulnerabilities.