Can the stock market really keep going up?

interactive investor's head of investment explains the stock market rally that is baffling even seasoned investors.

Compared with the pessimism of mid-March, markets are currently defying gravity, buoyed by a tidal wave of stimulus where central banks vie with each other to see who can deliver the biggest dose of high-powered money into the market.

Not to be outdone by their central banks, governments have also rediscovered the joys of Keynesian stimulus, delivering ever greater volumes of helicopter money to their grateful furloughed subjects.

With interest rates now at staggeringly low (or even negative) levels, bonds have moved from being a risk-free return to a return-free risk. If compromised supply chains caused inflation to jump unexpectedly, you would not want to be holding 30-year government bonds, whose price has an inverse relationship with interest rates and inflation.

As a result, equity markets seem to be the only game in town, since they at least have some chance of giving you a capital gain. 

The tech boom rolls on

The Nasdaq US technology index has reached all-time highs, up over 10% year-to-date. Across the demographic spectrum, everyone is embracing new technology, whether that is working or studying from home, socialising online or even just doing your weekly shopping.

And as well as tech, there is also enormous potential in those previously forgotten biotech companies as they help us to discover tests, vaccines and cures for Covid-19.

A new generation of investors has arrived

With much of their discretionary spending curtailed, a new wave of investors has discovered the joys of investing your savings in the financial markets. Those that have gotten involved are likely to be relishing the momentum trade that has seen markets push higher. 

Some more experienced investors, large and small, may be sitting on higher cash holdings, wary of investing at current valuations, watching with ever greater FOMO, or fear of missing out, especially if they bailed out some time in March, as the market marches inexorably higher. Until all these investors have finished (re)investing in the market, the path of least resistance remains upwards.

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Just in case that all sounds a bit too good to be true, it would be churlish to omit mentioning a few of the not inconsiderable downside risks that are readily apparent for all to see.

Second wave?

We think it’s all over, but what if that pesky R number pushes back up above 1 now that everyone is free to head out to Barnard Castle whenever they want? Governments have just about managed to keep the show on the road so far, but the yawning gulf between fiscal spending and tax receipts can only go on for so long before the bond market starts to wake up and take notice.

If countries cannot go back to work, governments cannot finance furloughed workers for ever.  Without a pick-up in demand for cars, houses and a wide range of consumer discretionary goods and services, the economic wheels may soon come off the bus.

In terms of the extent of the rally, we are potentially reaching tech bubble territory. In the US, equity valuations (in particular, the key measure of price/earnings (PE) ratios) are rapidly approaching the dizzying heights experienced shortly before the market crash in March 2000.

And if there are any downside surprises in those upcoming earnings, that denominator could quickly push the ratio even higher.

Or are we heading back to the 1930s?

Maybe we have been listening to the economic doom-merchants like Nouriel Roubini and Nick Taleb for too long, but there are surely strong parallels between the current situation and the dire events of the 1920s and 1930s.

Then, a huge stock market boom was ultimately undone by policy mistakes including global tit-for-tat protectionism (tariffs) and ill-judged monetary tightening, typically higher interest rates. We already have plenty of the former, but thankfully no sign of the latter – yet.

Overall, market participants are split between those who think that the weight of money and expectations of further stimulus is driving a liquidity rally that shows no sign of stopping, and those that believe the market is simply not factoring in the long-term reality of a post-Covid world.