We opened our email last quarter by saying that Q1 2020 would be a quarter we would remember due to the volatility and decline of the financial markets while the economy shut down due to Covid-19. Q2 however was not to be outdone. Despite the continuing impact of the Covid-19 along with the recent social unrest, US stocks were up 22% (Russell 3000), the largest quarterly gain since 19981.
As we look back at the last 6 months, we are thankful to not be watching the news, studying economic data or modeling Covid-19 cases looking for some insight into the direction that the market will move in the coming weeks (for more on this see: Why We Don’t Practice Tactical Asset Allocation). Perhaps you look back on the last 6 months and think that the market is crazy, too low or too high, way too volatile, completely irrational…or maybe all of the above! Outlined below are our thoughts about why we think the market is functioning as it is meant to (along with some support for not trying to predict what the market will do in the future).
The first thing to know is that markets are forward-looking, meaning that the current prices of each security (whether stock or bond) reflect the future expectations of investors. This includes expectations about the company’s future earnings as well as expectations about the future economic environment. It’s important to remember that in each transaction someone is buying and someone is selling. The buyer is expecting a positive return while the seller believes the price is fair, so they agree to the transaction (for more on this see: Are Stock Prices Fair?). We start with this basic concept because it is fundamental to understanding the continuing volatility and the market increase in the 2nd quarter.
Investors are constantly taking in new information so volatility should not come as a surprise. Since 1979, the average intra-year decline is 14%, yet 34 of those 41 years had positive returns2. What has made 2020 unusual is the size of some of the market movements from one day to the next. However, when taking into account a global pandemic, government-induced lockdowns and massive stimulus from the government, it is understandable with so much uncertainty and lack of clarity on the impact of these events how each piece of data being absorbed by the market had the potential to drastically change expectations, which leads to an increased magnitude of the market swings. We often say Volatility is the Price of Admission.
How are we to understand the returns of the second quarter? It is helpful to think about what is impacting investor expectations. At the current time, expectations are focused on Covid-19 and the impacts it has on all facets of economic activity. The US peaked in Covid-19 deaths on April 19th. As of June 28th, the number of daily deaths was down 84%3. Another data point would be unemployment, which fell 2.2% in June to 11.1%4. These kinds of data points cause investors to have increased expectations about future earnings of companies, which raises prices as that data is absorbed. These good pieces of data have not yet been realized in actual economic data such as GDP (gross domestic product), which we discussed in our recent blog post When Stocks and the Economy Diverge. We think the best way to understand the returns in the second quarter is that they were normal, but still unpredictable, market behavior. There was no guarantee that after poor returns in Q1, Q2 would rebound. There is also no assurance the strong performance of Q2 will continue into Q3. Covid-19 stats may continue to improve, but investors could start to care more about the election, causing other data points to diminish in how they impact the market. There is no way to know with any certainty how these trends will continue, much less how the market will respond.
One constant through all the craziness is that your financial plan should be updated as your life changes, not as Covid-19 statistics or economic outlooks change. We have two blog posts in the side panel that discuss various aspects of the CARES act and how they might impact you. As always, if you have any needs or concerns, we are here to help. Our office is back to functioning as normal with the option of virtual or in-person meetings.
1As measured by the Russell 3000 index
2Source: Dimensional Fund Advisors, Recent Market Volatility 3/4/2020
3Source: Covid-19tracking.com4Source: Bureau of Labor Statistics
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.