The first half of 2020 was one of the most volatile periods on record in stock markets. The crash and rapid recovery has contributed to what’s been an emotionally challenging time on many levels during the pandemic.
In the first weeks of the crisis, many people were worried about how bad things would get and whether the financial system would remain stable. Then, markets rallied, and relief took hold—things were going to be okay.
Now, I’m sensing from discussions with clients that we’re moving into a third phase of emotional reaction. Increasingly, I’m hearing people express concern about the sustainability of recent gains in stock markets. They’re worried we may have come too far, too fast, and might be slated for another crash.
To better understand where we are and where we may be headed, let’s examine how the markets have recovered.
- Massive economic support—Central banks and governments have intervened massively to support the financial system and the economy. Central banks have purchased bonds and governments have provided direct support to individuals and businesses. In Canada, these actions add up to about 12% of gross domestic product and it’s a similar story in the U.S. and other countries. That’s a staggering amount of stimulus compared to other recessions and has underpinned the stock market rebound. Canada has extended many of the pandemic-related benefits and the US is debating an additional large stimulus plan right now.
- Low interest rates—Central banks, through their open market operations, have stepped in to help the economy by lowering interest rates. This enables banks to offer loans and mortgages at lower rates and still be profitable. Lower interest rates filter through to stock markets in the form of lower discount rates on future cash-flows. In other words, future cash-flows or earnings become more valuable today and, in turn, justify higher stock prices. Central banks have made it clear that they intend to keep interest rates low for a long time to come, to ensure a strong recovery from the current recession.
- An uneven recovery—While stock market indexes have marched higher since bottoming out on March 23, the recovery has been uneven. In the U.S., it’s been led by the big growth stocks—the Amazons, Facebooks and Apples of the world. By contrast, value stocks and smaller company stocks haven’t bounced back to the same extent. The same goes for other stock markets around the world. While the U.S. market has regained its pandemic losses, markets in other developed and emerging countries have yet to broken-even since January 1st. Our portfolio tilts to value and small-cap stocks haven’t bounced back as strongly, but that also means that your portfolio is less exposed to the most expensive stocks in the market. International diversification will also continue to play an important role in protecting portfolios if the strong US market takes a step back.
Besides concerns about the rapid rise in stock prices, I’ve also fielded questions recently about the enormous amount of debt being accumulated by governments to finance aid packages. Will it end up sinking the economy and the stock market?
As I explained in my mid-year review, U.S. government gross debt as a percentage of GDP was at a similar high levels after the Second World War. Yet, the U.S. stock market increased strongly through the late 40s, 50s and 60s. It was the same story after the 2008-09 financial crisis when the stock market performed well despite sharply higher levels of public debt. These two historical episodes suggest there is no correlation between government debt and stock market performance.
As we’ve seen, there are solid reasons why markets have recovered from the pandemic sell-off. Does it mean they will continue to rise or will correct sharply after such a big run-up? We simply have no way of knowing. A large body of research has shown no one can consistently forecast market movements.
However, what we can learn from the volatility of the recent months is the importance of sticking with a broadly diversified portfolio that reflects your tolerance for risk.
A well-designed financial plan allows you to leave the worrying to the market gurus and be secure in the knowledge that despite short-term bumps you are positioned to benefit from market returns to build wealth over the long term.