In my last post, the market had just pulled back about 10% within a few days. Since then, the market not only declined about 34% from its late February peak, it also recovered just over 30% from the bottom. This market reminds me of two very famous lines from "The Godfather". First, in the original, Marlon Brando's Don Corleone is discussing how he can help his godson, Hollywood singer Johnny Fontane, with a problem. He simply says, "I'm gonna make him an offer he can't refuse." The Fed has tried to do the same thing by promising to pump unlimited amounts of money into the economy so support consumers and corporations, as well as give confidence to investors. So far, it appears to have worked. But...
The problem is the second quote, uttered by Michael Corleone in Godfather 3: "Just when I thought I was out, they pull me back in." This is where I believe the market is now. We are probably due for another pullback, but hopefully not as deep as the initial one. The recovery off the March lows initially made some sense in the context of some technical measures and a short-covering rally. (Short selling occurs when a security is sold first, thinking the market will fall; a rally sometimes occurs as investors buy it back later at lower prices). Only some of the 30% bounce makes sense to me, but the rest of the bounce is -in my opinion- too optimistic for just a few reasons.
- The market was overvalued prior to the late February pullback. Even a reasonable recovery (assuming that earnings and profits would be at pre-virus levels) should mean that the stock market would pull back to a lower value than the previously "overvalued" peak.
- Reopening states does not solve the main issue (the virus), it only helps with some of the residual effects (economic shutdown). As I've said previously, it will take a vaccine (or effective treatment) for consumers and corporations to see a clear end to the crisis and confidence in its sustainability.
- Consumer demand must also return, and could be much more measured. Some spending will return as unemployment drops, but it would also make sense that people may want to pay down debt or that has been incurred, or to increase savings.
- Corporations would also want to have some visibility regarding consumer demand before increasing their workforce or investing in capital expenditures. Manufacturers will likely work off inventory first before ramping up their production significantly.