On Tuesday, the S&P 500 hit a record high, defying Covid-19 and the related economic fallout. While the word “unprecedented” has become all too common as of late, it’s difficult not to invoke once again the concept in light of this financial market behavior. As we continue into the second half of 2020, there are a few things to keep in mind as the market surges on.
The first is that financial markets are rarely a reflection of the current state of the economy. This present moment is a potent reminder of that reality as the markets have recovered at an impressive pace even as unemployment rates stay in the double digits, and businesses continue to close. Financial markets are forward-looking, reflecting investors’ expectations of what will happen in the future, not necessarily what is happening in the present. At the moment, investors are incredibly optimistic about the resolution of the pandemic. They are hopeful for a vaccine soon and a quick economic recovery, which has contributed to the strong stock market returns this summer.
Secondly, while the markets may be optimistic about the future, it doesn’t mean that they’re behaving rationally. Across the board, assets appear to be near fair valuations if not approaching the expensive side of things. If current prices reflect earnings expectations, it’s worth pondering what is driving those expectations. One of the driving forces behind the surge in market valuations is the growth of mega-firms doing big business in the wake of the pandemic even as small companies continue to go out of business. In our current environment, this is to be expected. Whether or not it is sustainable is another question.
Finally, there are a broad range of potential risk scenarios on the horizon. These risks include another wave (or waves) of the virus, the possibility of unexpected inflation, political fallout from the upcoming election, and a future increase in taxes to pay for the stimulus. Additionally, there are risks we haven’t even considered such as an unforeseen natural disaster or trade war.
In light of all of this uncertainty, how then ought we respond? We believe the answer is twofold: diversify and plan. We continue to believe that diversification is the best way to position for an unforeseen future environment. While we don’t know how exactly this crisis will unfold or what will follow it, we can be on the defensive by spreading our exposure across different types of assets. This will enable us to take advantage of bonds’ stability should we experience another pullback, or the Large Cap markets’ strength should the rally continue.
Furthermore, we don’t want to be caught unprepared. If we know that we will have cash needs in the future, we want to have a plan for meeting them that doesn’t require us to sell out of a potential down market, should one occur. As we look towards the end of the year and beyond, we want to continue in diligence and humility, facing the many potential outcomes with the tools at our disposal to ensure long-term success.