For nearly the past three months, Wall Street and investors have dealt with some of the wildest volatility they've ever seen. In a span of 33 calendar days, the benchmark S&P 500 (^GSPC +0.68%) lost 34% of its value. That's the quickest descent in history from a recent high. (It's taken an average of 11 months for the S&P 500 to lose 30% during previous bear markets.)
Furthermore, we've witnessed an unprecedented economic impact from the spread of the coronavirus disease 2019 (COVID-19). The coronavirus pandemic shut down nonessential businesses throughout most of the country and has put an estimated 33 million people out of work, based on initial jobless-claim filings over the previous seven weeks.
Despite this, the stock market has clawed its way back, ending the previous week well off its lows. In fact, the technology-heavy Nasdaq Composite is actually higher than where it began the year. This has a lot of folks wondering if the market has put in a firm bottom.
Image source: Getty Images.
While I (nor anyone, for that matter) can't say whether the S&P 500 will take out its March 23, 2020 lows, I do feel pretty confident that we're in a bear market rally and that another stock market crash of sorts is in the offing. Allow me to lay out my reasoning.
Why has the stock market rebounded so much if the economic data is so bad?
The first question we have to ask ourselves is why the stock market has rallied back so significantly? I believe there are a number of reasons that help to explain this sharp snap-back rally.
First, much of the country has been on mandated stay-at-home orders from their respective governors, and nonessential businesses have been shut down. Short-term investors have been laser-focused on the number of new coronavirus cases, which in recent weeks have leveled off due to these mitigation measures in the United States.
Second, we've seen the Federal Reserve willing to bend over backwards to support the U.S. economy with unlimited quantitative easing, and watched as the federal government has passed multiple rounds of stimulus, including the $2.2 trillion Coronavirus Aid, Relief, and Economic Security (CARES) Act. The CARES Act is what's responsible for sending stimulus payments of up to $1,200 (or $2,400 for couples) to individual taxpayers, as well as apportioned nearly $350 billion for small business loans and $500 billion to distressed industries.
Third, we've watched big businesses within the S&P 500 predominantly top Wall Street's lowered first-quarter expectations. The FAANG stocks have been particularly strong in 2020, with established tech brands largely responsible for driving the market higher.
And fourth, investor emotions tend to drive short-term price movements, which led to an initial overreaction to the downside in March. The rebound we're seeing is simply a normalization of that emotion-fueled overreaction.
Image source: Getty Images.
Here's why stock market crash 2.0 is inevitable
Now that we've established the basis for the recent rally, let's take a closer look at the factors likely to result in the stock market rolling over, once again.
1. Federal stimulus is providing a false sense of hope: To begin with, the federal stimulus has provided a sense of false hope to investors. Sure, a greater percentage of Americans paid their rent in May than did so in April, but that probably has a lot to do with more folks receiving their stimulus payment or an extra $600 per week in unemployment benefits.
But according to a Money/Morning Consult poll from April 22, 74% of 2,200 stimulus money recipients surveyed expected their payout to last four weeks or less. What's more, the extra $600 per week for unemployment benefits ends July 31, 2020. Once these federal dollars run out, rental, mortgage, and credit delinquencies are going to soar, and that's going to put a major crimp in consumption spending.
2. Business activity isn't going to bounce back quickly once restrictions are lifted: Second, we're not going to simply flip the switch and have businesses go back to normal. In the U.S., each state has been handling their reopenings differently. Some will quickly ramp-up activity, while others have no chance of fully easing restrictions until well into summer.
The reason I mention this is because there are up to 33 million people out of work who may not be able to step right back into a job come May, June, or even July. Some restaurant staff I've spoken to in my home state of Washington have mentioned that their establishments may remain closed to dine-in customers during the phase 2 opening, where capacity remains under 50% and bars remain closed. Opening restaurants at sub-50% capacity may not be worth their while, relative to the nominal expenditures associated with takeout orders. Translation: Business activity isn't going to bounce back as quickly as everyone thinks.
Image source: Getty Images.
3. A second infection wave is possible/probable: Another concern for the U.S. economy is that a second round of coronavirus infections is possible, if not probable.
To be clear, it's not just the U.S. that's at risk of a second wave of infections. Without a vaccine, any country is susceptible to an increase in daily infections. But the U.S. is unique in that it's the outlier of developed countries when it comes to its daily confirmed case curve.
Whereas nearly all developed countries have seen a steady decline in their COVID-19 daily infection rate (i.e., most look like a bell curve), the U.S. hasn't turned that corner. Rather, infection rates have merely leveled off on a daily basis right as some states begin reopening for business. Though we have witnessed marked progress in New York City, the No. 1 global hotspot for coronavirus cases, the rest of the country as a whole isn't faring as well.
4. Wall Street can't set any bars for Q2 earnings: Fourth, don't overlook the role that Wall Street has played in aiding this bounce back in the stock market. Typically, publicly traded businesses provide sales and profit guidance, and not-so-surprisingly, those businesses consistently surpass Wall Street's per-share profit expectations.
However, things are going to be different beyond the first quarter. The vast majority of companies have removed their 2020 guidance, which leaves Wall Street with little to go on with regard to second- and third-quarter estimates. You may not realize it, but investors rely on consistent earnings "beats" to push the stock market higher. With Wall Street no longer able to set the bar low for public companies to step over, we're going to see investors having no choice but to focus on year-over-year or sequential quarterly operating performances, rather than how well a company did relative to Wall Street's low-bar expectations. And hint, hint... those year-on-year comps will be ugly!
5. The Fed can't prevent a recession: Fifth and finally, investors need to understand that the Federal Reserve can't prevent a coronavirus-fueled recession. There's no question that the Fed's unlimited quantitative-easing measures are going to make liquidity easier to access for businesses. But the fact remains that lowering interest rates to spur lending does no good when consumers are too afraid to leave their homes or spend money.
Image source: Getty Images.
Here's what I'm doing
While there's no guarantee the stock market pushes to new lows or even rolls over, I believe there's enough evidence to prepare in the short term as if there'll be a stock market crash 2.0.
What am I doing, you ask? First of all, I'm not planning to sell anything I own. The stocks I've purchased were bought with a long-term thesis in mind. With the exception of one of my 26 holdings, those investment theses still hold water today and should continue to do so no matter what COVID-19 throws at the U.S. economy.
I'm also collecting dry powder like a squirrel prepping for winter. By this I mean I'm gathering cash to put to work for what I suspect will be a significant second wave lower. I don't plan to use any margin when buying stocks if the market rolls over and suggest you avoid it, too.
Lastly, I'll be itching to buy, albeit in small quantities. Everyone has their preference for investing, and I consider myself a nibbler. With most brokerages removing commissions to buy and sell stocks, it's made it easier than ever to put money to work in the market.
It could still be a few weeks (or even months) before the S&P 500 reverses course, but if and when it does, I'll be ready to put my capital to work.
