Why does the stock market keep going up? How to invest in the current environment?

It is quite perplexing on the backdrop of such dire economic news that the stock market seems to be going up almost every day. S&P 500 as of 8-May-20 is already up by 33.7% from the lows of 2,191.86 it hit on 23-Mar-20 less than a month and half ago. But on the other side, the economic news continues to be negative. Q1 2020 GDP decreased by 4.8% annualized and is expected to drop by a whopping 30–40% for Q2 2020. The labor department just released the data on unemployment for April which has hit a historic high of 14.7% at 20.5 million workers losing their jobs. The S&P 500 seems to ignore this key piece of information and continues to rise and end the week of 8-May-20 up almost 3.5% at 2,929.80. This has left a lot of people scratching their heads and looking for an explanation. Let us look at the various factors at play here:

1. While the data published by various government agencies are backward looking, the stock market relies on “forward looking outlook”. Most of the negative news being published has either already been priced in or is better than the worst-case scenarios predicted by many experts. This happened in the 2008 financial crisis as well, when the US GDP did not start to grow again until Q3 2009, however the markets had turned around by the end of Q1 2009. As an investor you are always looking for how things are looking ahead in the future and in this case, the numbers that everyone is looking at are the number of new cases and deaths which have started to stabilize and in some parts even get better. This coupled with the increased testing and providing necessary support to the health-care workers albeit slower than what we would want is still encouraging.

2. The Fed has taken unprecedented steps of providing liquidity in the markets. The Fed started by buying treasuries and agency backed securities, but quickly expanded to municipal bonds, investment grade corporate bonds and eventually into the high-yield space as well. Granted that the purchase of high-yield will be restrictive and will only benefit the companies which were initially IG but have been down-graded by the ratings agencies in the wake of the coronavirus. This has created a “signaling effect” for the investors leading them to believe that the Fed has got their backs.

3. The interest rates have been slashed to 0–0.25% making it cheaper for companies to borrow, and investors looking for yields are going back into the stock market. Low interest rates incentivize investors to look at riskier assets for higher returns and this time is no different. This is explained best by Warren Buffett in an interview on CNBC where he compared interest rates to gravity and that higher interest rates depress the prices of stock while low rates give it a boost and the rate cuts by the Fed have just added fuel to the rise of the stock prices in the last few weeks. Coupled with the fact that the Fed is providing “unlimited QE” has resulted in a lot of money flowing into the high-yield and stock market.

4. Technology stocks have played a big part in the resurgence of the stock market. IT was almost 15% of the overall weightage in the S&P 500 in early 2002 which has grown to over 25% as of 30-Apr-20. “Big-tech” stocks like Apple, Facebook, Alphabet, Microsoft, Amazon have all come back to their all-time highs or are near it. All these tech giants have showed resilience in the current environment. Their Q1 results are testament to the strength of their business models where they were minimally impacted by the global pandemic, and in certain cases was even positive for them. Each of these companies have continued to grow in double digits in revenue terms for Q1 2020 except for Apple, which was mostly flat but showed a double digit growth in its services business. Amazon had to up its hiring to meet the additional demand for its retail delivery business which has seen a surge due to people staying home and ordering online. The rest of the big-tech companies have continued to hire albeit at a slower pace. For businesses like Amazon, Microsoft and Alphabet, the shelter-in-place has resulted in a lot of companies quickly adopting their cloud platforms giving their business a boost while certain other products/services take a back-seat.

5. After the 2008 financial crisis, the US government had taken some strict steps to ensure that the financial sector is prepared for another crisis. The increased capital requirements, multiple stress tests that the large banks must go through has resulted in a much more robust financial sector. The tier 1 capital for the largest banks which used to be between 5–8% in 2008–09 have increased to 11–12%. All the large banks have been able to provide adequate provisioning as shown in their Q1 results and are a part of the solution this time around by partnering with the Fed and SBA to provide the necessary support for small businesses to weather the global pandemic.

Don’t get me wrong, we are still not out of the woods, and some sectors will take months if not years to recover, like the airlines, hotel and tourism industry. Even though the shutdowns have been in place only since the last few weeks of the quarter, but that already resulted in double digit drops in their revenues for the quarter. And for some like the retail industry, the pandemic has accelerated the slow decline that they were already facing due to the changing trends. J. Crew’s bankruptcy filing is probably the first of many that we will see in this sector. We will see huge bailouts and/or bankruptcies in these industries, but given the low weightage in the broader market indices, their impact will be minimal and will be quickly over-shadowed by the growth in big-tech.

But all this is predicated on the US being able to control the pandemic from getting any worse. The shutdown that has been put in place has helped flatten the curve and ensured that the worst-case scenarios are not hit. However, removing the restrictions too soon can result in a resurgence in the number of cases and subsequently deaths in the following weeks or months. And there is nothing more the markets hate more than uncertainty, this is the one thing that can put a damper in the continued rise in the markets.

So, the question then arises as to how to take advantage of all this information and what is the best strategy to invest in the markets. Given the current conditions, continuing to invest or stay invested in the markets is the right strategy with the support of the short term SPY put options. These short term put options will provide the necessary protection for the investors to ride the volatility if the situation gets any worse while also giving the upside for the investors if the economic and health outcomes continue to improve. As an investor there is a small premium to be paid for buying these options, but it will give you the peace of mind to protect against the unchartered territories that we are currently navigating.

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