The stock market is in rally mode, presumably at least somewhat on the back of positive vaccine news from Pfizer and Moderna. However, in an ironic twist, this positive vaccine news could make it harder for the market to go higher. Here’s how:
- No more wall of worry to climb
- Tech stocks that dominate the S&P 500 could struggle to move higher
- The possibility of less pressure for a large stimulus bill
Stocks climb a wall of worry
Investors have been nervous about the market for much of the last 6 months. This has been evident in investor sentiment polls, high cash levels, and overweight allocations to fixed income. In light of all this, stocks have gone higher anyway, climbing a wall of worry along the way. Will stocks still go higher if there is less to worry about? They could, but we think it will be harder.
As sentiment shifts from negative to positive, investors are more willing to invest available cash or move money from bonds to stocks. This unwind in sentiment can help stocks rally as cash finds its way into the stock market. The last two weeks has seen this sentiment unwind in action as the S&P 500 has rallied 10%. Over that time, investor optimism has soared, per the American Association of Intelligent Investors (AAII). In fact, the spread between bullish investors and bearish investors reached a 1 year high this week (from Ycharts):
This is not a reason for stocks to fall. However, it does suggest a lot of negative sentiment has been reversed. In other words, if everyone thinks stocks are going to rise, then they’re presumably already invested accordingly. That lessens the pool of available investors who can still come in and drive markets higher. Later this month we’ll get data that shows if cash moved off the sidelines and into the market. We suspect it will show that is exactly what happened recently.
Tech leaders stop leading
In a change of this year’s trend, tech giants like Apple and Amazon are not the stocks leading the market higher the last two weeks. What is leading? Small and mid cap stocks, value stocks (like banks and healthcare), international stocks, and emerging markets. As builders of diversified portfolios, we’re actually pretty happy with these recent developments. However, as it relates to the S&P 500’s ability to go higher, that part is trickier. The S&P 500 is dominated by five tech stocks: Apple, Microsoft, Amazon, Facebook, and Google. These companies have benefited from Covid in two unique ways:
- Their brands have been fortified by work-from-home and lockdown culture
- The monstrous cash flows they generate are even more valuable in a low interest rate environment
A vaccine could hurt these exact companies on both of these fronts:
- Less brand stickiness and demand once we “return to normal”
- Interest rates have risen in anticipation of this potential return to normal, dampening the appeal of the big five’s cash flows.
Again, these aren’t reasons for the market to move lower as much as they are dynamics that could keep it from moving significantly higher. The structure of the S&P 500 relies greatly on these five tech stocks, so if they stop going higher it will be harder for the index to keep going higher too. That’s our best guess for why we’re starting to see the S&P 500 lag behind other market segments. The chart below shows the performance of the S&P 500 (SPY), small caps (IJR), and international stocks (VEA) month-to-date:
Small caps and international stocks are outperforming large cap stocks month-to-date. The outperformance is even more significant when measured from the moment positive vaccine news came out this past Monday:
Where’s the stimulus?
If a vaccine is one thing the market has been expecting for a long time the other is another stimulus bill. The economic recovery remains bumpy, and we outlined clear evidence last month that shows the market’s desire for more stimulus. However, with a vaccine on the horizon the political appetite for a grand stimulus deal could be fading. Do you think republicans are anxious to work with democrats on a huge deal? The vaccine gives them a proverbial carrot in front of a donkey to hold onto during negotiations with democrats.
Let’s also acknowledge that President Trump received the most votes of any incumbent President ever, and republicans picked up seats in the house. The takeaway is that even though Trump may have lost the election, he is still wildly popular and will no doubt be a political kingmaker in future elections. Do you think republicans will be itching to do a deal when Trump is firing off tweets telling lawmakers not to work with democrats who support voter fraud? President or not, Donald Trump is going to be a factor in US politics for the foreseeable future.
Unlike our first two points this one could actually cause the market to go lower, not just keep it from going higher. The market is absolutely expecting a stimulus bill. So if we get into December or January and it’s not clear that one is on the way, or that it’s too small, you’ll probably see a negative market reaction.
Think differently
The consensus view is that a vaccine is going to help the economy get back to normal and propel the stock market even higher. While that could be true, it’s also possible that the positive effects a vaccine will have on the economy in the future are being priced into the stock market today, thus, pulling forward future returns.
Stocks have been rallying for months in the face of negative investor sentiment. Will that continue now that investors are feeling more optimistic? The tech giants that are so important to the S&P 500’s performance may not do as well in a return to normal environment. Lastly, stimulus negotiations could be complicated by the anticipation of a vaccine and President Trump’s everlasting influence over republicans. Add it all up and the market may have a harder time moving higher than one would think.
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Well here may be the very definition of a disconnect from the market and a healthy economy. Yes, the market may not bounce in the face of a successful vaccine as you point out. But certain industries and the millions of folks who depend upon them – restaurants, aviation, travel, entertainment – are essentially DOA abent an efficacious vaccine. So here is the case where the overall economy greatly benefits even though the stock market (five giant firms) don’t. I’ll take the healthy economy any day … because in the long run, we will all benefit … including the big five you mentioned.
I agree with everything you say. Your comment gets to the point of a much more complicated discussion: what is the relationship between the market and the economy? On a day to day basis, or even week to week, they aren’t that connected. But over the long term they definitely move in the same direction. But keep in mind, as a leading indicator, the stock market will always be one step ahead of the economy, both in good times and bad. We saw that in March when the stock market bottomed before the worst of the economic recession had set in.