Thoughts on the Stock Market Rebound
Just over a month ago, we discussed the sell-off in the stock market caused by the current pandemic. At the time, there was a great deal of uncertainty clouding what the future would look like. When the article was published, we had 4% of the confirmed cases we have today in Canada. Markets across the globe were down ~30%, and an index that measures investor fear was at its highest level on record. Since then, stock markets around the world have risen at some of the fastest rates since the Great Depression. Most major markets have recovered ~50% of their March losses.
This market rebound has taken place as we’ve seen several negative, record-breaking economic stats and with a significant uncertainty still present. As a result, the market rebound has many people wondering if we’ll eventually see a drop in stock prices. While I don’t know if the market will go up or down from here, I wanted to share a few important points for consideration.
Factors that could justify current stock prices
There are three factors I’d like to discuss that could help justify the rebound.
Investor’s expectations for future returns may have declined over the last two months.
We’ve seen an unprecedented response (i.e., speed and magnitude) from many governments and central banks.
There is a battle between two risks competing for investor attention.
Return expectations
Since January, the return offered to owners of 10-year government bonds declined from ~1.6% to 0.56% in Canada. This means investors are willing to accept a lower future return today than they were two months ago. If this is the case for bond investors, it may be the case for those buying stocks as well. Therefore, even many expect earnings to decline over the next few years, the current value of those earnings may still be close to what they were in January.
If stocks return to their all-time highs, it’s not the same as saying the stocks are as valuable as they were in January. It’s saying they’re as valuable, relative to all other investment options, as they were in January. When you consider other options, paying current prices could make sense. However, you’ll likely need to lower your expectations for future returns.
Unprecedented response
Governments around the globe have responded to the crisis with support for those impacted. Programs include payments to individuals who lost their job, small business rent relief, partially forgivable loans and more. Also, central banks have lowered interest rates and provided significant lending to governments and businesses alike.
These activities have helped to limit the worst-case scenario. As we discussed during the sell-off article, investors consider the full range of potential future outcomes, and often overweight the worst-case scenario. As these scenarios come off the table, the value of stocks can jump significantly. This is the same reason that stock markets can rise even though data seems worse than expected. Each new piece of information removes a bit more of the uncertainty and fear.
Competing risks
There are two risks that investors are struggling with right now.
The risk of investing before a further market decline.
The risk of waiting and watching the market rise.
With an increasing number of recoveries to reference (e.g., 1932, 1987, 2003, 2009) investors may be more confident than ever that stocks will eventually recover. If enough investors are optimistic the economy will improve in the next few years, they may be willing to look past current uncertainty. I wrote about this idea recently when discussing the concept of an overvalued stock market more broadly. The main takeaway is that even if the market is overvalued, which is difficult to determine, that doesn’t guarantee it will drop in price.
Closing remarks
We’ll likely see further volatility in the stock market over the coming year. As we’ve discussed previously, these short-term fluctuations are irrelevant if you have the right time horizon and risk tolerance. Setting up an emergency savings account if you can, will help provide peace of mind through the coming months. In addition, if you need your investments soon, the market is providing an opportunity to adjust.
Investing in a low-cost, diversified investment and ignoring the headlines has historically provided the surest way to a secure financial future. If you’re not sure what to do in these times, please feel free to reach out with any questions.