The big-time potential of small cap stocks [PODCAST]
Pinpointing winners requires a sound investment process.
Pinpointing winners requires a sound investment process.
Despite facing the greatest global health crisis of our generation – and the economic fallout that came with it – the stock market roared to record highs in 2020.
For many, this may seem like a disconnect. Why does the stock market keep going up when the economy doesn’t seem to be anywhere close to functioning normally? I thought it might be helpful to share a few thoughts about why the markets can sometimes appear detached from the everyday economy, as well as some observations on how the recession of 2020 was an economic event like no other.
In 2020, we as a society did something we’d never done before. In the interest of public health, we voluntarily shut down a large portion of our economy. Prior to the emergence of COVID-19, our economy was in pretty good shape. Like many other investment firms, we were optimistic for the year 2020. The Federal Reserve (Fed), which had scared the markets by raising rates in late 2018, appeared to be on the sidelines with an expectation of low interest rates for an extended period. We were in the midst of the longest economic expansion in American history.
Recessions often begin for one of two reasons. Sometimes, a recession is driven by a cyclical overheating of the economy. You can think of this as a typical “boom and bust” cycle. In recent decades, the “boom” would often be followed by the Fed raising rates to control inflation, which would drive the economy into a recession. Other times, a recession can be caused by structural excesses in the economy. The global financial crisis of 2008-09 is an example of this type, with a bubble in the housing market leading to the crash in financial assets of almost all types.
What was unique about the recession of 2020 was that it was driven by neither an inflationary, cyclical bust nor by bubbles in particular assets. As I noted, the recession was largely the result of our decision to shut down much of our economy to protect public health. Now, because the recession didn’t have the same causes as prior recessions and didn’t begin in the same way, it’s not entirely surprising that the recession looked different than other recessions in important ways.
In most recessions, cyclical excesses lead to a collapse in those areas that are most economically sensitive – industries such as manufacturing or banking. The less economically sensitive sectors that tend to hold up better in a recession are generally service-related areas such as healthcare and education.
But in the COVID recession, many service-related jobs were affected in unexpected ways. In a typical recession, a dental hygienist, for example, would still have work. People might delay some care and some folks might lose dental coverage from their employer, but people will generally continue to go to the dentist, especially for their children. But it’s a different story when dental offices are required to close because of the pandemic. This dynamic played out in many normally recession-resistant service areas.
Conversely, because the economy was fairly healthy going into the recession, other sectors weren’t hit as hard as they were in some other recessions. Banks, in particular, were very strong and well capitalized from the years and regulations following the financial crisis of 2008-09 and were well positioned to weather the storm. Manufacturing, while taking a short-term hit due to temporary shutdowns, recovered more quickly than in a typical recession as factories implemented COVID safety procedures and came back online to meet demand.
Another critical and unprecedented aspect of the 2020 recession and recovery is the magnitude of intervention by the Fed. The Fed had clearly learned its lesson from the financial crisis of 2008-09 and did what it said it would do next time around. The Fed provided massive monetary stimulus through asset purchases on an unprecedented scale, and it did so almost immediately when the pandemic emerged in March.
The market has rebounded dramatically from its bottom in March of 2020, when the Fed made its announcements. This brings me to my question, the one with which we began: why would the stock market go up so much when many parts of the economy are still struggling?
It’s important to keep in mind that the stock market is a forecasting mechanism. When you buy a stock, you’re buying a claim on all the future earnings of that company. The vast majority of these anticipated future earnings come from beyond the next year or two. If we see light at the end of the tunnel, if the market is able to see past a rough 12 or 18 months, the market will often price in a recovery in corporate earnings and in the overall economy well before it actually takes place.
We saw large gains in the stock market when favorable vaccine results were announced. The Fed has reiterated its commitment to providing necessary liquidity to the markets and economy. The new administration has already pushed through a new $1.9 trillion stimulus plan in 2021, while stocks continue to trade at elevated valuations in anticipation of a recovery in the broader economy and of better days ahead.
All information and representations herein are as of 03/16/2021, unless otherwise noted.
The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Thrivent Asset Management, LLC associates. Actual investment decisions made by Thrivent Asset Management, LLC will not necessarily reflect the views expressed. This information should not be considered investment advice or a recommendation of any particular security, strategy or product. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.
Any indexes shown are unmanaged and do not reflect the typical costs of investing. Investors cannot invest directly in an index.
Past performance is not necessarily indicative of future results.