Is Optimism in the Market Unrealistic?

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Markets have a tendency to, shall we say, overreact. After all, the trick is to get in the market before it moves, causing people to pile on rumors and drive prices on rollercoaster rides.

We needn’t look further than the reaction to the COVID-19 pandemic. Stock markets around the world crashed within a couple of weeks, only to rebound by half of the drop a couple of days after touching bottom.

Of late, markets seem to be breaking into new areas of risk appetite, banking on a fast recovery from the lockdowns. It’s more than reasonable to question the sanity of the markets in general, and in this case, even more so.

In fact, there are good arguments to be had on both sides. There are even good arguments to support a third side: that markets will trend sideways for a while.

So, What’s Going On?

Let’s review what drove the stock market’s wild moves, since equities are a good guide of sentiment.

On Feb 21, analysts noticed that there was a lack of liquidity in the bond market. Businesses were drawing down on their credit facilities in anticipation of tough economic times. This is the spark that sent markets around the world tumbling.

There was almost a month of crashing markets, but what brought an end to the freefall was reversing what had caused it: central banks (led by the Fed) basically promised unlimited liquidity.

With access to funds guaranteed, markets reversed course and returned to a more “sensible” level.

Going Higher?

Central banks are providing unprecedented levels of liquidity, which is allowing investors to keep putting money into the stock market. This is the primary argument for why the market would continue its rise – even as the economy shrinks by historic measures.

No one is being forced to liquidate their positions, and many see it as a buying opportunity.

The thing is, markets can’t be too disconnected from the underlying economy. Rising stocks as companies cut dividends and suspend guidance is not sustainable. This is the argument that some analysts propose for why there could be another move down in equities.

This would be the W-shaped recovery. If the economic reports are really bad these months, it could drive the markets lower despite all the “cheap money”.

The Predictions

Arguably, the yield curve inversion once again accurately predicted a recession.

What’s it saying now, though? Well, the curve has risen substantially, showing that investors are putting their money where their mouth is, projecting a quick recovery by the end of the year.

The thing is, protracted downturns like the last one (which had a W-shape) are based on uncertainty. At the time, it wasn’t known exactly what was wrong with the market, and it was impossible to predict how long it would take to balance out.

This time the cause of the downturn is simple and clear: the need to prevent the spread of COVID-19. Which means the solution is just as simple: a vaccine or reasonable treatment becoming available. It doesn’t mean we’ll return to “normal”; just that by removing the uncertainty that keeps markets down, their natural buoyancy will reassert itself.

Is expecting a treatment/vaccine by the end of the year overoptimistic? That’s more of a medical question than a market analysis one.

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