Why is the stock market rallying when the economy is in free fall?
The economy is in tatters with metrics after metrics printing numbers as worse as the Great Depression.
Official unemployment rate hit 14.7 and the expanded unemployment rate (U6) hit a record 22.8%. However, the stock market is just 5–10% off its highs after having fallen 30–40%. How can that be?
The main reason why the stock market is soaring even though the economy continues crashing is the FED, or the Federal Reserve. In the past, when US economy hit a downturn, the Fed would act as “the last resort”. So, only when the economy got worse enough the Fed would intervene. They would normally start with more subtle actions such as “Lowering the Rates” and “Providing Liquidity” to banks. If that fails to re-ignite the engine, then they would do more forceful actions like “Buying Qualified Assets”, which essentially means that Fed would print money to buy bonds from financial institutions such as Banks. The “Buying of Assets” is how Bernanke shored up the markets when all else failed.
So what’s different this time?
- This time the Fed “preemptively” stated that it will buy assets — The Fed didn’t wait for the economy to crash, it straight away went to the most potent tool in its arsenal, the “Buying of Assets”. This aggressive action leads to a faith in equity investors that the Fed has “got their back” and it removes fear from markets. So investors start buying stocks.
- Fed flooded the market with Liquidity — This time Fed printed more money than anybody imagined. Since mid of March, Fed has printed $1.5 Trillion of money.
Which further led to $3+ Trillion worth of liquidity in the market as measured by the M2 Money Supply.
A big chunk of this excess liquidity created ends up in buying of stocks and in mitigating the risk factors that impact stock prices.
3. The Fed is buying High yield Debt ETFs — In an unprecedented and controversial move, the Fed announced that it will also buy low-quality assets such as High Yield ETFs. This has had a profound impact on stocks. Usually, the biggest reason for stocks to fall is the fear that companies will default on the loans. So investors start selling “junk bonds” (non-investment grade bonds). This creates panic in the stock market as interests of equity holders are subordinate to that of bondholders. At the same time, the companies are not able to “issue more bonds” to raise more money for surviving downturn as the bond market is “frozen”. By buying the low-grade bond ETFs, the Fed “un-froze” the junk bond markets and diminished the panic on the street.
Another reason why stock market is overly joyous is the hope that coronavirus will have only a temporary impact. Before COVID hit US, the US consumption was in relatively good shape. This downturn was created by a biological problem and not by an organic problem such as excess consumer debt during the housing crisis. So, several market participants believe that once a vaccine or a drug is found the economy will quickly bounce back to previous levels. As stock market is forward-looking, a temporary blip is discounted as having minimal impact on valuations.
However, despite all the optimism, only a handful of tech-based companies have recovered while most industries are still in the dumps. Several marquee investors such as Warren Buffett and Carl Icahn have publicly stated they don’t believe in this rally.
