Brief Note About Last Week's Stock Market Rally

From the S&P 500 low of 2,191.86 set Monday morning to the close Thursday afternoon, US stocks rallied 20.3% in three days - the fastest 3 day rally in 125 years of recorded stock market data.

The news of the coronavirus outbreak is overwhelmingly bearish (thousands more Americans will die in the weeks to come.)  Although we're impressed that Congress enacted a $2 trillion stimulus bill in two weeks, it will be months, perhaps year end, before we see anything "normal" in the US economy.  We expect a second $2 trillion stimulus by June.  So why did the stock market rally so violently to the upside?

The human brain is programmed to project straight lines to infinity.  10,000 years ago, if you were a cave person tracking caribou, it would be logical to follow the direction set by the caribou tracks.  It's natural to look at the stock market chart of the last month, conclude that stocks will be worth zero in two weeks.

However, the stock market is more like a bungee cord; the further stocks extend in one direction (bullish or bearish) the more dramatic the reversal in the other direction.  As stocks had fallen 35.3% in 4 weeks from the February 19th all-time high (the fastest decline of such magnitude in stock market history,) we knew a rebound was coming.

We have had so many conversations with clients in the past two weeks along the lines of, "Why can't we sell all our stocks now, buy back into the market later when things have calmed down." 

We explained that while the worst of the pandemic is still ahead of us, the 35% decline in stocks has already fully discounted the economic impact.  We were less worried about stocks falling another 5 or 10%, much more worried about missing the rallies in the other direction. If we take clients out of stocks now, by the time we get back in, stocks will be 20, 30, 40% higher.  We can't make up that handicap, which means that clients will not have all the resources they should have in 10, 15, 20 years for retirement.

Our compromise in many cases was to raise some cash in taxable accounts, but leave retirement account fully invested.  Other clients have put money into their accounts.  As long as those clients understood that, "This investment is 5 year money," (money you won't need for 5 years) we have put those funds into stocks.

On Friday stocks fell 3.4%.  Yes, that is expected.  A bungee cord jumper initially falls towards the earth with high velocity, is caught by the cord, slingshots skywards, falls back with less force, oscillates a few more times, and then is raised back to the jump platform.  We can expect stocks to oscillate around current levels for several weeks or months, then start rising again.
Ultimately, the stock market cares only about revenues, earnings and interest rates.  Current and projected revenues (the top line) produce earnings (the bottom line.)  The value of present and future earnings is discounted back to present using current interest rates. 

Let's use an extremely simple model of a stock market that produces $1,000 at year end for 5 years, and then stops.  Interest rates in our example are 5%.
The present value of the first earnings payout is $1000/(100%+5%) = $952. 

The present value of the second earnings payout is $1000/((100%+5%)^2) = $907. 

The present value of all 5 earnings payments is $4,329.

Near term cash flows are worth more then cash flows further in the future.

Now we can understand how stock prices bounce around.  If investors expect the value of the earnings in years 1-5 to fall suddenly to $750, then the price they would pay for those earnings would fall to $3,247.  However, if interest rates fall from 5% to 1%, the present value would jump from $3,247 to $3,640.

Right now, there is incredible uncertainty about corporate earnings over the next 1-2 years.  But meanwhile interest rates have fallen to near zero.  Here's what we know: companies like airlines, hotels and restaurants will take an incredible hit to earnings because of lost activity that cannot be replaced.  But other companies like Amazon will see a huge surge in revenues as everyone orders from home.  Meanwhile, companies that produce tangible goods like cars will see some revenue lost now, replaced later.

In falling 35%, the US stock market discounted a 35% fall in earnings over the next 5 years, which would be extreme given that the US economy is expected to contract by 10% over the next two quarters, then recover. 

As we get further into the end of this year and the beginning of 2021, and normal human activity resumes as the pandemic recedes (vaccines and herd immunity will ultimately cap the number of fatalities), the earnings situation will improve.  As earnings come up, so will stock prices.

As bad as all this seems, our asset allocation strategy actually assumes something horrible will happen every 10 years.  For our clients who are already retired, their April 1st draw is good to go (unreduced.)  For our clients whose businesses or paychecks are adversely affected,we've raised cash from bonds to tide them over till cash flows resume.  For everyone else, we're counseling no dramatic changes to their portfolios.

For sure, we will continue responding to clients' phone calls as fast as they come in!

We will continue sending bulletins and scheduling webinars as fast as we have actionable information.

If you would like to learn more about how we advise our clients, visit HeronWealth.com or schedule a call with me.

Best regards,
David Edwards, President
Heron Wealth
www.HeronWealth.com

Direct: 347 580-5288
Mobile: 917 705-3893

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