US equity markets are enjoying decent, broad-based gains on Wednesday. The S&P 500 is up 0.6%, the Dow is up 0.75% and the Nasdaq 100 is up 0.2%. Most of the losses endured by stocks over the course of the last two days of last week and this Monday have now been unwound; the S&P 500 pulled back from record levels just under the 4400-mark last week to at one point as low as the 4230 mark earlier this week, a 3.6% high to low drop. However, with the S&P 500 index right now trading around the 4350 marks, the majority of this drop has already been erased and the index is back to within about 1.0% of its record highs. US equity market sentiment remains very positive, suggests price the action.
Why have US stock markets rebounded so strongly?
There seems to have been a broad recognition that the extent of the losses seen earlier in the week were overdone. Some market commentators framed the risk off move seen over the course of the last two days of last week and the start of this week as more “emotional”/ “psychological” in nature than actually being based on the fundamentals. Indeed, as analysts keenly continue to point out, the main fundamental pillars that have underpinned the blistering more than 30% rally in the S&P 500 since the start of November 2020 remain largely unchanged.
Firstly, markets generally still seem to assume/expect that FOMC monetary policy over the course of the rest of this decade is set to remain very accommodative (by historical standards), a reflection of market expectations that long-term inflation will remain fairly subdued. Such expectations are reflected in long-term bond yields, which remain not much above historic lows, and market-based measures of inflation expectations, which remain well anchored around the Fed’s long-term 2.0% target. In other words, whilst equity investors expect that some relatively modest monetary policy tightening will be instore over the coming years, they very much seem to expect that Fed is not going to be yanking away the cheap money/liquidity punchbowl anytime soon, or at least in any way that would upset low-interest rate environment loving equity markets.
Secondly, despite rising fears about the spread of new, more infectious Covid-19 pandemic variants (like the Indian delta variant and South African beta variant), especially in countries with low vaccine coverage, markets still assume that vaccines will eventually bring the pandemic to an end. Or, at least, widespread global vaccines rollouts should eventually put us in a position that whilst Covid-19 may be endemic, the immune protection offered by the vaccines should reduce its infection/death rate to something that is “palatable” and no longer requires lockdowns and restrictions on international travel. To the pessimists, this might seem far too optimistic; infections are surging all over the world, in low vaccine coverage area (where deaths will be very high and economic growth damaging lockdowns very likely) and high vaccine coverage areas alike. But so far, the experience in highly vaccinated parts of the world like the UK that are also seeing a rapid rise in Covid-19 infections is that the pre-vaccine rollout linkage between infections and then ultimately deaths has been drastically reduced. How much it has been reduced is the big question. But, based on the data so far, it appears that fully vaccinated people are at a significantly lower risk of being hospitalised and dying than the unvaccinated. As long as this remains the case, a return to the strict lockdowns seen in 2020 and 2021 in highly vaccinated parts of the world seems very unlikely. While it may yet be some time before the world is back to “normal” (economists argue that the pandemic has irrevocably changed the structure of the economy, so there will be no complete return to the old normal), US equity investors seem to take solace in the knowledge that the existence of the vaccines and the successful rollout seen across many developed countries means the risk of a return to lockdowns is low, meaning the global economy should be expected to continue to recover.
Elsewhere, while emotions and psychology may have played a role in the velocity and depth of the drop in the S&P 500 on Monday, it is also likely playing a role in the recovery. Today some equity market analysts argued that “FOMO” (fear of missing out) is partly behind the strength of the rebound, or, in other words, equity investors rushing in to buy the dip out of fear that stock prices might quickly recover back to record levels and the opportunity to buy at lower prices would have been missed. Based on price action in US equity markets over the past 12 or so months, such fears are justified. Since the start of the year, the S&P 500 has undergone “corrections” of between 3-6% from record highs on six different occasions. In all but the most recent correction, which we are still in the middle of recovering back from, the index has promptly recovered back to fresh record levels. Only twice in the past 12 months has the S&P 500 seen a correction of more than 6%, and both of those corrections occurred between the months of September and October 2020. This was a difficult time for risk appetite, with equity investors unnerved by US election uncertainty and prior to the “game-changing” news that the Pfizer vaccine was effective in protecting against Covid-19. Since November 2020, every time the S&P 500 has fallen below the 50DMA, the dip has been bought and fresh all-time highs have been set before the next mini correction.
Is it really so surprisingly that such a pattern continues to repeat itself time and time again? Another reason traders are giving for the rebound from lows this week has been the fact that we seem to be in the midst of another strong US earnings season. Today saw upbeat earnings from Verizon and Coco-Cola and both trade in the green as a result. As long as earnings continue to broadly beat or at least come out in line with expectations, equity investors will be given reassurance that stock valuations (which are high by historic standards given accommodative monetary policy and low bond yields) are justified. For a “real” correction in equity markets to occur (i.e. a drop of 10-20% or more), we are going to need to see the core pillars that have underpinned the rally come under threat. That could come in the form of a new, vaccine resistant Covid-19 variant that puts us back to square one with regards to the pandemic (scientists seem to think this would be an unlikely development), or an unexpected, unwelcome hawkish shift in Fed policy expectations.