What is the relation between economic activity and the stock market over the business cycle? This blog post presents some of the conclusions from my book From Main Street to Wall Street. One conclusion is that the business cycle has a strong impact on the stock market, another that post-1945 business-cycle dynamics are very different from pre-1945 business-cycle dynamics.
In this third part of my small four-part series of blog posts presenting glimpses of my book From Main Street to Wall Street, I turn to its examination of the relation between the stock market and the economy over the business cycle. It follows my first post (link), where I explained why I wrote the book, and the second (link), where I presented some of the book’s conclusions with respect to the long-run relation between the stock market and the economy.
The business cycle
In this part of the book, I explain what the business cycle is, what characterizes it, what causes business-cycle fluctuations in economic activity, and economic theories that explain business cycles.
Today, May 4, 2021, the Council for Return Expectations publishes its updated forecasts. We still expect very low – negative – returns on safe assets, though not as negative as we expected six months ago. We also expect marginally lower returns on risky assets. Compared to six months ago, we thus expect a lower equity risk premium.
I chair the Council for Return Expectations (link). Danish banks and pension companies use our forecasts when they project how their customers’ savings will develop. In this blog post from July last year (link), I describe the history of the council, who we are, why we publish expected returns, what they are used for, and so on.
Twice a year, we update our expectations. Today, we publish our latest forecasts.
What is the long-run relation between economic activity and the stock market? From Main Street to Wall Street analyzes, inter alia, this question. Here, I present some of the conclusions.
As mentioned in my previous post (link), From Main Street to Wall Street describes how economic activity influences financial markets, in particular stock markets. It distinguishes between the long-run and the shorter-run relation. The “long run” refers to decades, even centuries. The short run refers to months, potentially a few years.
This post presents some of the book’s conclusions with respect to the historical long-run relation between the economy and the stock market. This is both an intriguing and fascinating topic, and the conclusions are not always as one would have guessed a priori.
My book – From Main Street to Wall Street (link) – has been published. This blog post explains why I wrote the book and its contents. The next three posts (that will be sent out in due course) will present some of the analyses and conclusions from the book.
start in 2008. The financial crisis was at its worst.
I was a young professor of finance. I studied financial crises (my Ph.D. is on currency crises) and the relation between the macroeconomy and expected stock returns.
It’s this time of the year. This post recalls events of 2020. It has been such an unusual year, so different from what we expected. Luckily, there seems to be light at the end of the very long and dark tunnel, and – I hope – that 2021will be considerably more joyful than 2020.
2020 started out so well. The roaring twenties and all that. Wuhan was a city I had not heard of, corona a beer people tell me is best served ice-cold with a slice of lime (I do not drink beer, tough I do enjoy wine), and social distancing words we would only get to know too well. Today, we know that Wuhan is a Chinese city with more than eleven million inhabitants and a marketplace where it presumably all started, corona also means something terrible, and social interaction is an activity we have come to miss so dearly.
This corona recession started in February 2020. Officially, it is still ongoing. But, perhaps, it has in fact already ended. This might seem confusing but it helps explaining the performance of financial markets during this “recession”.
In my soon-to-be-released book From Main Street to Wall Street (link and link), I – among many other things – carefully examine the historical relation between the business cycle and financial markets. I verify that stock markets typically perform considerably better during expansions than recessions. In the book, I examine and explain why this is so. I also explain that this is not a bulletproof finding. It is not always so. Sometimes stock markets do fine during recessions. Is this recession one of them?
If history is any guide, it will be four good years on the stock market if Biden wins on November 3. Historically, stocks have performed so much better under Democratic presidents. The question is whether history will be a guide also this time around.
Are Democratic or Republican presidents better for the stock market? To evaluate, let us recall the performance of the US stock market under Trump – a Republican – and compare it to its performance under Obama – a Democrat and Trump’s predecessor. Afterwards, let us look at the full history of the stock market under Democratic and Republican presidents. Finally, let us discuss what it implies for this election and the next four years on the US stock market.
looming recession and financial market panics, the Fed intervened heavily in
late-February/early-March, lowering the Fed Funds Rate to zero and expanding its
balance sheet dramatically. In spite of this, markets kept on panicking. Then,
suddenly, on March 23, everything changed. Stock markets started their rally.
This was not because the Fed lowered the rate or expanded its asset purchases
even further, nor because the economic data improved. What happened? The Fed made
an announcement. Nothing else. It is a fascinating illustration of how
expectations can change everything on financial markets.
Much has been written about the massive interventions of the Fed during February and early March. In my previous post (link), I list Fed interventions as one of the reasons why the stock market is back to pre-crisis highs. In this post, I dig one step deeper and explain the fascinating story of how the Fed said something and thereby rescued markets.
Asset purchases and rate reductions did not save markets in February/March
Let us start by
illustrating how the actual Fed interventions (interest rate changes and asset
purchases) did not save markets in
March. The Fed lowered the (lower range of the) Fed Funds Target Range to 1% from
1.5% on March 2 and then again to 0% less than two weeks later, on March 14. At
the same time, it bought Treasuries and mortgage-backed securities to the tune
of USD 600bn per week. These interventions succeeded in lowering yields on government
and mortgage-backed bonds, but did not cheer up stock markets.
This graph shows how
Treasury yields came down significantly in February/March, by basically
1.5%-point (from close to 2% to close to 0.5%; I show yields on 10-year
Treasuries in this graph), as a result of reductions in the policy rate (the Fed
Funds Rate) and asset purchases by the Fed.
The graph also shows that the SP500 continued falling throughout February/March. In other words, the massive interventions by the Fed in late-February/early-March (and these interventions really were massive – buying for USD 600 bn per week and lowering rates to zero is indeed a massive intervention) did not convince stock markets that the situation was under control. And, remember, these were not minor stock-market adjustments. It was the fastest bear market ever (link).
What turned the tide?
On March 23, the SP500 reached its low of 2237, a drop of 31% compared to its January 1 value. Since then, everything has been turned upside down and markets have been cheering, as the above graph makes clear.
What happened on March 23? The Fed had its finest hour. It did not do anything. It merely said something. A true “Whatever it takes” moment.
As you remember, a “Whatever it takes” moment refers to the July 26, 2012 speech by then ECB-president Mario Draghi (link). The speech was given at the peak of the Eurozone debt crisis. The debt crisis pushed yields on Italian and Spanish sovereign bonds to unsustainable levels. Italy was too big to fail, but also too big to save. The pressure on Italy was a pressure on the Eurozone construction. Mario Draghi explained the situation and said the by-now famous words:
“But there is another message I want to tell you. Within
our mandate, the ECB is ready to do whatever it takes to preserve the euro. And
believe me, it will be enough.”
Investors understood that the ECB would be ready to buy sovereign bonds to save the Euro. Markets calmed down. Italian and Spanish yields fell. And this – and this is the point here – without the ECB actually intervening, i.e. without the ECB buying Italian or Spanish bonds. The announcement that the ECB would intervene was enough to calm down investors.
Why is this relevant here? Because on March 23 the Fed sent out a press release, announcing that:
“…the Federal Reserve is using its full range of authorities to provide powerful support for the flow of credit to American families and businesses.”
And, then, as one of the new features announced the:
“Establishment of two facilities to support credit to large employers –
the Primary Market Corporate Credit Facility (PMCCF) for new bond and loan
issuance and the Secondary Market Corporate Credit Facility (SMCCF) to provide
liquidity for outstanding corporate bonds.”
This statement turned everything upside down. The important thing is that this turn of events happened without the Fed using any money at all. It was a “Whatever it takes” moment (though, perhaps not as Dirty-Harry dramatic as Mario Draghi’s “And believe me, it will be enough”): The Fed announced what they would do, investors believed the Fed, and markets started cheering. It is a prime example of how investor expectations influence financial markets.
What are the PMCCF and
SMCCFs, why did the Fed announce them, and
why were their effects so dramatic?
The lowering of the Fed Funds Rate and the purchasing of Treasuries succeeded in lowering yields on safe assets, such as Treasury bonds, as explained above, but did not lower yields on corporate bonds. In fact, during the turmoil in late-February/early-March, credit spreads (the spread between yields on corporate bonds and safe bonds) widened dramatically. When yields on corporate bonds rise, it becomes more expensive for corporations to finance their operations. And, when yields rise a lot, as in February/March, investors get nervous about the profitability and survival of firms.
This graphs shows how yields on both the least risky corporate bonds (Triple A) and speculative grade bonds (Single B) rose dramatically in relation to 3-month Treasury Bills, with yields on lower-rated bonds (Single-B) naturally rising more than yields on higher-rated (Triple-A) bonds.
The important point in the picture is that the spreads continued rising throughout late-February/March, in spite of the intensive interventions described above, i.e. in spite of Fed purchases of government and mortgage bonds. The Fed was happy that safe yields fell, but was concerned that credit spreads kept on rising. Volatility in corporate bonds markets also rose (link), making the whole thing even worse.
More or less all firms saw their funding costs increase, even when there were differences across firms in different industries, with firms in the Mining, Oil, and Gas, Arts and Entertainment, and Hotel and Restaurant sector hit the hardest, and firms in Retail and Utilities sectors less affected (link). The Fed became nervous because higher funding costs for firms affect firms negatively, causing them to cut jobs, reduce investments, etc.
The Fed decided to act. It announced on March 23 that it would launch two new programs, PMCCF and SMCCFs. The PMCCF is the ’Primary Market Corporate Credit Facility’ and the SMCCF the ’Secondary Market Corporate Credit Facility’. Primary markets are where firms initially sell their newly issued bonds. The PMCCF should thus ease the issuance of newly issued corporate bonds, i.e. help firms raise funds. Secondary markets are where bonds are traded afterwards, i.e. the SMCCF should ease the trading (liquidity) of already existing corporate bonds.
The effect on equity and credit markets of the announcement of the PMCCF and SMCCFs was immediate and spectacular. Immediately after the announcement, credit spreads narrowed (see, e.g., link, link, and link).
Interestingly, stock markets reacted immediately, too. The stock market, thus, did not react to the lowering of the Fed Funds Rate and the extensive expansion of the Fed balance sheet in late-February/early-March, but reacted strongly to the announcement that the Fed would buy corporate bonds on March 23.
This (supercool, I think 🙂 ) graph shows developments on corporate bond and equity markets. The graph shows the spread between yields on AAA-rated corporate bonds and 3-month Treasury Bills and the stock market inverted, both normalized to one on January 1. The graph for the inverted stock market means that when the SP500 is at 1.45 on the y-axis on March 23, the stock price at January 1 was 45% higher than it was on March 23.
The parallel movements in equity and credit markets are striking. Equity and credit markets moved in parallel during January, when stock markets rose and credit spreads narrowed, in late-February/early-March when credit spreads widened dramatically and stock markets fell like a stone, as well as after March 23, when both credit spreads and stock markets improved spectacularly. Since then, stock markets have continued to rise and credit spreads have continued to narrow.
The correlation between the two series is an astonishing 0.93 for the January 2 through May 31 period.
The Fed has experience with and a mandate to buy mortgage-backed
securities and Treasuries. It had no such experience when it comes to purchases
of corporate bonds and corporate bond ETFs. This means that the Fed could not
start buying corporate bonds on March 23, it needed an institutional set-up. It
created an SPV with capital injections from the Treasury and leverage from the
New York Fed, it asked a financial firm (Blackrock) to help them purchase the
bonds, etc. These things take time. The Fed only started buying corporate bond ETFs
in mid-May and corporate bonds in mid-June.
Given that the Fed only started buying bonds and ETFs in May/June, the spectacular
turnaround on March 23 really was due to the announcement only.
In slightly more detail, it played out as follows. The March 23 announcement primarily dealt with higher-rated corporate bonds (Investment Grade), and spreads narrowed immediately. On April 9, the Fed announced that they would expand “the size and scope of the Primary and Secondary Market Corporate Credit Facilities (PMCCF and SMCCF)”, buying bonds that were Investment Grade on March 22 but had been downgraded since then as well as corporate bond ETF. High-yield spreads tightened even more (link). Today, the Fed explains that the programs allow the Fed to buy “investment grade U.S. companies or certain U.S. companies that were investment grade as of March 22, 2020, and remain rated at least BB-/Ba3 rated at the time of purchase, as well as U.S.-listed exchange-traded funds whose investment objective is to provide broad exposure to the market for U.S. corporate bonds.”
The actual purchases began in May/June, several
months after the announcement. Interestingly, the purchases themselves have had a
modest impact only. First, the amounts of corporate bonds and corporate bond ETFs
bought pale in comparison with the amounts of mortgage-backed securities (MBS) and
Treasuries bought. The Fed has bought MBS and Treasuries to the tune of USD 3,000bn
this year. It has “only” bought corporate bonds and ETFs for around USD 12bn. The
amount used to buy corporate bonds thus corresponds to less than 0.5% of the
amount used to buy MBS and Treasuries. This graphs shows the daily purchases. Using
the latest figures from August 10, the Fed has basically stopped buying
So, the Fed has not bought a lot of corporate debt. It has, however, the power to buy a lot. The PMCCF and SMCCF set-up is such that the Treasury has committed to make an USD 75bn investment in the SPV that buys the assets (USD 50bn toward the PMCCF and USD 25bn toward the SMCCF). The New York Fed then has the ability to level this up by a factor of ten, i.e. the Fed can buy corporate debt for up to USD 750bn. This is a sizeable fraction of the total US corporate bond market. This, that the Fed can potentially buy a lot, helps making the program credible and thus helps explaining its powerful impact.
Given the success of the PMCCF and SMCCFs, commentators have started arguing that the Fed should be allowed to buy corporate bonds as part of its standard toolkit (link). This might be relevant, but purchases of corporate bonds by central banks raise a number of dilemmas:
Keeping zombie firms alive. By easing up stresses in corporate bond markets, the Fed calmed down markets. This was the intention of the PMCCF and SMCCF announcementsand it worked. It eased access to funding for firms, and firms have raised a lot of cash as a consequence (link). It is positive that malfunctioning markets are stabilized, but if central bank intervention makes markets too cheerful it may allow firms that in principle should not receive funding to nevertheless get it. And, thereby, to keep firms alive for too long, and increase firm leverage too much. Basically, the fear is that programs such as the PMCCF and SMCCFs create too many zombie firms. My CBS colleague Fabrice Tourre and his co-author Nicolas Crouzet has an interesting paper that examines this (link). Fabrice and Nicolas find that when financial markets work perfectly (no disruptions), Fed intervention might be detrimental to economic growth. On the other hand, if markets are disrupted, Fed intervention might prevent a too large wave of liquidations. One thus needs to determine when markets are disrupted “enough” to rationalize interventions in credit markets. This is no straightforward task.
Distributional aspects. By buying some bonds but not others, the Fed exposes itself to the critique that it helps some firms at the advantage of other. To alleviate such criticism, the Fed has been very transparent and publishes a lot of information about the bonds it buys, the prices at which it buys the bonds, etc. (link). Nevertheless, it is easy to imagine that some firms at some point will start saying ‘Why did you buy the bonds of my competitor, but not my bonds’?
The Fed put. The more the Fed intervenes when troubles arise, the more investors get reassured that the Fed will also come to the rescue next time around. When the Fed saves markets, it is sometimes called the Fed exercises the “Fed Put”. The potential problem here is that if investors believe that the Fed will exercise the Fed put, investors will be tempted to take on even more risk. Those of us concerned about systemic risks get nervous.
So, in the end, the announcement of the PMCCF and SMCCFs was crucial during this crisis. There are, however, important dilemmas that need to be addressed when evaluating whether such programs should be part of the standard toolbox. I am not saying they should not. I am saying that one needs to be careful.
launched massive “traditional” interventions in late-February/early March,
lowering the Fed Funds Rate and buying mortgage and government bonds. In spite
of these very large interventions, equity and credit markets kept on tail
spinning. When firms struggle, it hurts economic activity and employment. The
Fed got nervous.
The Fed announced – and this is the whole point here; they only announced – that they would start buying corporate bonds. Markets turned upside down. Credit markets stabilized, credit spreads narrowed, corporate bond-market liquidity improved, and stock markets cheered. And, all these things without the Fed spending a single dime until several months after the fact. Even today, the Fed has spent very little (some might say that USD 12bn is a lot, but compared to asset purchases of USD 3,000bn, it pales).
It was a “Whatever it takes” moment. It illustrates how managing investor expectations can be crucial. Understanding this announcement is thus important for understanding the behavior of financial markets during this pandemic.
The behavior of the stock market during this recession raises three main questions: (i) why did stock markets fall so spectacularly during February/March, (ii) why did stocks rebound so spectacularly during April/May, and (iii) why is the stock market currently at its pre-crisis level? My previous post (link) presented the stylized facts and addressed stories that cannot explain the facts. In this post, I provide some potential explanations.
I my previous post (link), I mentioned that the rebound in the stock market since its low in March cannot be explained by (i) revisions to the economic outlook – in fact, economic forecasts were revised down during spring, (ii) a preference for just a few (FAANG) stocks, as the rebound has been international and broad based, even when large-cap stocks have done particularly well, (iii) a hypothesis that this recession is not particularly bad – in fact, at least in the short run, this recession is much worse than the 2008 recession, or (iv) the fact that markets also recovered after 2008 – markets always recover, i.e. this is not an explanation.
What can explain it, then? First, a warning: I do not want to raise expectations too much (sorry). I will not be able to offer a full explanation of these puzzles in an app. 1,900 words blog post. Also, as you will see, puzzles remain, even if we can explain some things. Finally, I have not seen a good explanation of these puzzling stylized facts (though Gavyn Davies’ piece in the FT is a good place to continue after reading this post; link). Hence, it would not be serious nor academic if I claimed that I could explain everything. What I can do, though, is to provide some hints at what might be relevant parts of an explanation.
Explanations that contain elements of truth
Earnings suffered more in 2008
In the end, earnings and not economic activity (GDP) determine stock prices. In the long run, there is a strong relation between earnings and economic activity, which is why we focus on economic developments when we try to understand stock markets. The relation is not one-to-one, though, in particular in the short run. Hence, let us discuss earnings.
Earnings suffered dramatically in 2008. Often, we look at 12-month
earnings, as quarterly earnings are volatile. 12-month reported earnings per
share for the S&P500 came in at 6.86 in Q1 2009, which is app. 10% of
12-month reported earnings in Q1 2008. I.e., earnings fell by a mind-blowing
90% during the financial crisis of 2008.
Earnings fell in Q1 2020, too, but much less: From USD 139 per share in Q4 2019 to USD 116 (12 month reported earnings), i.e. by 17%. At the time of writing, around 90% of companies in the S&P500 have reported earnings for Q2 2020. Earnings (12-month reported) seem to be coming in at close to USD 96 per share, which is a drop of 17%, too, compared with Q1. Earnings have thus dropped by 17% during each of two consecutive quarters. But, and this is the main thing, these drops pale in comparison with autumn 2008. In autumn 2008, earnings dropped by 68% from Q3 to Q4 and then again by 54% from Q4 2008 to Q1 2009. This figure shows the quarterly percentage changes in 12-month reported earnings of the S&P500 in 2008 versus 2020. “0” on the x-axis is Q2 2020, respectively Q4 2008. The drop in earnings was just so much larger in 2008.
“1” on the x-axis in the figure is thus Q1 2009 and Q3 2020, i.e. firms’ expected earnings in Q3 2020 (and actual earnings in Q1 2009). If these expectations hold true, earnings are expected to do relatively fine going forward.
Earnings do fall from Q1 to Q2 this year. Earnings surprises matter, too, though, i.e. whether actual earnings are higher (or lower) than expected. At the time of writing, around 80% of companies have reported positive earnings surprises for Q2. This, that actual Q2 2020 earnings are better than expected, helps explaining why stock prices rise currently.
If investors primarily look at earnings, this helps explaining why stock prices fell considerably more in 2008 than they have done during this recession and why the stock-market recovery took longer in 2008. Earnings have simply not suffered so much this time around. For that reason, stock prices have not suffered so much this time around either.
Monetary and fiscal policies have been aggressive
Another factor that helps explaining why stock prices today are at
pre-crisis levels, in spite of the severity of the recession, is that policy
interventions have been aggressive. Immediately, at the onset of the crisis,
monetary policy turned very expansionary. This can be illustrated by the weekly
changes in the Fed balance sheet, as in this graph:
The figure plots the weekly changes in the Fed balance sheet due to purchases of financial assets, in millions of USD. The Fed balance sheet changes when the Fed buys/sells financial assets. During March this year, there were weeks when the Fed intervened to the tune of USD 600bn. This is an enormous amount of money. It is, by way of comparison, more than twice the weekly amounts spent during the financial crisis of 2008, the figure also shows.
At the same time, yields are very low. This forces investors to buy risky
assets if they want some kind of return, supporting stocks.
In addition to very aggressive monetary policy, fiscal policy has also been
Why did stock prices fall during February/March?
OK, so earnings have not fallen as much as in 2008, earnings for Q2 2020
have surprised positively, monetary and fiscal policies have been very
aggressive, central banks pump liquidity into the system, and interest rates
are very low, implying that investors need to invest their money in risky
assets if they want a positive expected return. These features help explaining
why stock prices today are not much lower than in the beginning of the year.
But, if this is the story, why did stock markets drop so dramatically in March?
Changes to expectations to earnings
Earnings have dropped in Q1 and Q2, even if considerably less than in 2008. Perhaps the stock-price drop in February/March was simply due to a downward revision in expected earnings. Alas, this is not the case. Landier & Thesmar (link) have an interesting analysis where they look at analysts’ expectations to the earnings of S&P500 companies during Q1 and Q2 2020. They find that analysts cut their expectations to earnings of S&P500 firms, but not so much that it can account for the drop in stock prices during February/March. In other words, the drop in stock prices in February/March cannot be explained by analysts reducing their earnings forecasts.
If the drop in expected earnings cannot account for the drop in stock prices in February/March, what happened then? Financial economists have a straightforward way of explaining this. Stock prices are discounted cash-flows. To understand stock price movements, we must understand cash-flow and discount rate movements. When the fall in expected earnings is not large enough to account for the drop in stock prices, discount rates must have increased in February/March. In other words, during February/March investors required a higher expected return if they should invest in stocks. This is also the conclusion in Landier & Thesmar and in Gormsen & Koijen (link). Basically, this is the conclusion in most empirical asset-pricing literature: stock prices move too much to be justified by movements in cash-flows. Discount rate variation is the reason, the literature concludes.
When stock prices move, and it cannot be because of cash-flow movements, it
must be discount-rate movements. This is fine, but it is also somewhat
tautological: If A = B + C, and A moves but B does not, then it must be because C moves.
A more difficult question is what makes
discount rates move in the first place? I.e., what is the deeper economic
explanation? Perhaps/probably risk aversion spiked, when investors in February
suddenly realized the severity of the virus. Perhaps/probably some market
participants faced funding constraints. And so on. In other words, I agree that
discount rates most likely spiked during March, but I am not 100% sure why and
I do not know if the increase in risk aversion is large enough to account for
the increase in discount rates, and thus account for the drop in stock prices.
So, a potential reason why stock markets have done better than in 2008 is
that earnings have not suffered as much as in 2008 and central banks have
flooded the market with liquidity (and yields are at zero). The reason why we
saw a massive fall in stock prices in February/March, and an unprecedented
rebound during April/May/June, then probably is that discount rates increased
during the early phase of the crisis, and then stabilized. This is a story that
somehow makes sense.
Two things are still strange (to me at least), though.
First, if stock prices are at their right levels now, why did they have to fall so much in March? OK, because risk aversion increased and funding conditions tightened. But, if risk aversion increased in February because investors understood that a recession was looming, why would investors turn less risk averse three weeks later, when economic forecasts just kept on deteriorating? Probably the Fed and the Treasury (via monetary policy and fiscal policy) eliminated the spike in risk aversion via aggressive policy interventions, but it is still not 100% clear how to reconcile these features of the data.
Second, the behavior of earnings has been surprising. During recessions, earnings normally contract much more than economic activity. So, when economic activity in 2020 contracts much more than in, as an example, 2008, a reasonable hypothesis is that earnings in 2020 would contract much more than in 2008. This has not happened.
To some extent, this graph summarizes both the explanation of the relatively mild response of the stock market to this recession and the remaining puzzle:
The figure shows how earnings dropped 68% from Q3 to Q4 2008 but seems to drop “only” 17% from Q1 to Q2 this year. This explains why the stock market has performed considerably better during this recession compared to its performance in 2008, for instance. On the other hand, the figure also shows that GDP dropped by 10% from Q1 to Q2 this year and “only” by 2% from Q3 to Q4 2008, i.e. the fall in economic activity is five times larger during this recession. It is puzzling that earnings drop so much less during this recession when economic activity contracts so much more.
So, the relatively modest contraction in earnings helps explaining the relatively fine performance of the stock market during this recession, but it is difficult to understand why earnings have behaved reasonably well. Perhaps this is because banks were suffering in 2008, but are able to help firms getting through this recession. Perhaps it is because firms have been able to adapt better this time. We do not really know. From an academic asset-pricing perspective, it is interesting that the stock market has behaved so differently this time around, compared to how it normally behaves. From an investor perspective, we can only hope that the stock market will keep on behaving in a different way than it usually does, as, otherwise, stock prices will fall going forward.
The facts that earnings have done better than in 2008 and that monetary policy has been very aggressive help us understand why the stock market has done well during this recession. Some puzzles still remain, though. For instance, why have earnings done so reasonably well, given the severity of the recession, and why did risk aversion increase so dramatically in February only to normalize few weeks later, in spite of the worsening recession. Perhaps the sensible answer is that this recession has been unusual in many dimensions, and some things will remain difficult to understand.
The behavior of the stock market during this recession has been perplexingly. To understand it, we need to answer three main questions: (i) why did stock markets fall so spectacularly during February/March, (ii) why did stocks rebound so spectacularly during April/May, and (iii) why is the stock market currently at its pre-crisis level? This blog post explains why these stylized facts are so difficult to understand jointly.In my next blog post (link), I will offer my interpretation of the evens.
the stock market during this recession has been a like watching a roller
coaster. The fall in late-February/early-March was the fastest bear market in history,
the rebound has been historically fast, too, and – in spite of the worst
recession ever – the stock market is currently back at pre-recession levels.
Somebody leaving for the moon in January and returning now would not be able to
see any trace in the stock market of the worst recession ever. This is in stark
contrast to normal recessions. People interested in financial markets and the
economy should be puzzled.
The problem – in a nutshell – is that if you claim that you understand why stocks are currently at pre-recession levels, then you face a challenge explaining why we needed to go through the fastest bear market ever during February/March. On the other hand, if you claim that the fast fall and rise in markets was just a short-lived technical blip (perhaps due to funding squeezes and fear), then you face a challenge explaining why that technical blip should result in a loss to the tune of USD 20 trillion (link). Finally, if you claim that you understand why markets fell so fast in February/March (perhaps because we were facing the worst recession ever – which, by the way, is a good explanation), then you face a challenge explaining why markets recovered so strongly in April/May/June, as the recovery cannot be explained by a brighter economic outlook. In fact, we have seen continuous downgrades of the economic outlook. E.g., the IMF WEO in June lowered its April forecasts for global economic output to –4.9%, from –3.0%. A huge downgrade. Strange that stocks recover in spite of this.
In this post, I describe the facts. I also review a couple of suggested, but wrong, explanations. In my next post (that I will publish next week), I will offer my view on what has been going on.
Here is an
updated version of a graph that I have presented earlier. It shows the Danish,
US, emerging market, and world stock markets (MSCI), normalized to one on
January 1, 2020:
Stock markets reached a temporary peak on February 19, after which they tanked dramatically. As mentioned here (link), it was the fastest US bear market in history.
has been equally spectacular. The US stock market is already back at its
January 1 level. World and emerging markets are still a few percentages behind,
but, basically, they have also recovered from the crisis.
In the US,
it was the fastest bear market ever, as mentioned. In this graph, I document that
it has also been one of the fastest recoveries. I calculate rolling 11-week
gains/losses in the SP500 during the last 50 years.
As you can see from the encircled peak on the right-hand-side of the graph, from its bottom on March 23, the SP500 gained app. 45% until June 8. The graphs shows that no other 11-week period since 1970 has witnessed such a large gain (I cherry-pick the 11-week period, but the main message is that the rebound has been spectacular, and this message is robust).
You hear/read many explanations. Some of them are just not correct.
It all boils down to FAANG
Some claim that it is not the overall stock market (typically these people refer to the SP500) that has recovered. Instead, some argue, it is all due to FAANG (Facebook, Apple, Amazon, Netflix, and Alphabet’s Google). It is true that the behavior of FAANG has been impressive and has driven a significant part of the SP500’s recovery, but this is not the whole story. As you see from the first graph above, emerging markets have recovered, too. This is obviously not due to FAANG. Also, some markets, such as the Danish, have recovered even more spectacularly than the US market. Not FAANG either. Even US small-cap stock have recovered. Not fully, but significantly. The Wilshire US Small-Cap Index gained an astonishing 57% during the March 23 through June 6 period. True, small-cap stocks are still (early August) 12% below their January 1 level, but when small-cap stocks have rebounded spectacularly, too, it emphasizes that this is not all about all FAANG, even when FAANG stocks have done very well.
Markets also recovered after the 2008 financial crisis
This is a no-brainer: Markets always recover. The point here is that this rebound has just been amazingly strong. In this graph, I compare the behavior of the SP500 during autumn 2008 and the corona crisis. “0” in the figure is September 19, 2008, respectively February 21, 2020:
During the first couple of weeks of this spring’s crash, it looked like autumn 2008. The pain was short-lived, though. Stock markets fell for a couple of weeks and then rebounded. In 2008, stocks just continued falling.
It has taken a couple of months to recover this time around. After the
financial crisis of 2008, it took more than two years. This figure shows that
the US stock market was back at its summer-2008 level in early 2011 only, and the
world stock market later still.
This recession is not as bad as 2008
It should be obvious by now that this argument is very wrong indeed. I
have argued myself that there is hope that, when we get a vaccine and economic
activity picks up again, the economic rebound will be stronger than in 2008,
the reason being that we entered this recession with a more “balanced” economy
than in 2008 (in 2008, we had a housing bubble, a weak financial sector, etc.).
Nevertheless, the short-run loss this time around is just so much larger than
Last week, we got figures for GDP in the US and Europe. This graph
compares the cumulative falls in real GDP in the Eurozone and the US in Q3+Q4
2008 with the cumulative drops during the first two quarters of this year.
US real GDP fell by more than three percent in Q3 and Q4 2008, whereas
Eurozone real GDP dropped by five percent in autumn 2008. It was a severe
recession in 2008. Nevertheless, it pales compared to this recession. This time
around, US GDP has fallen by more than ten percent already and Eurozone GDP is
down by a staggering 15% during the first two quarters of 2020.
What about the length of the recovery? After 2008, it took around two years
before economic activity had reached its pre-crisis level. This figure shows
for, e.g., the Eurozone that it will last more or less equally long this time (expectations
for 2020 and 2021 are from the EU Commission, Spring 2020).
The figure shows that Eurozone GDP was 5% lower in Q4 2008 compared to Q2 2008 whereas it is 15% down in Q2 2020 compared with Q4 2019. After eight quarters, GDP is basically back at its pre-crisis level. This means that the recovery is expected to be stronger, but this recession is just very deep.
In other words, this recession is much deeper – one can multiply the drop in 2008 by a factor of three or so to get the drop this time – and it will take several years before economic activity is back at pre-crisis levels. This means that the short-run cost to society is bigger this time around (a deeper fall stretched over the same period).
And, in spite of this very strong recession, stocks are doing fine. That is perplexing.
Above, I have presented stories that cannot explain what has been going on. In my next post (link), I will offer my view on this.