Predicting Turns on Wall Street
Wall Street got the pandemic right. Or did it? For the past two months, financial market commentators have been stumped by the stock market’s resiliency. The common refrain has been that the market is too optimistic given what seems to be crisis after crisis. With a pandemic still ongoing, Apple and a growing list of companies are trading at all-time highs. The NASDAQ just hit a record high while the S&P 500 is nearly up for the year. Fixed income markets remain shockingly robust. A closer examination of how the past three months transpired shines light on the idea that Wall Street tried to predict the pandemic’s turn without actually knowing what such a turn would look like.
Market Truths
There are two truths when it comes to how Wall Street functions:
1) Markets are forward-looking. A company’s stock price is not based on how that company performed in the past. If a company reports stellar earnings for the quarter that just ended but then reveals bankruptcy is on the horizon, the market is not going to make sure the strong results that occurred in the past are valued appropriately. Stock prices are determined by expectations of what will happen in the future, and more specifically, a company’s future cash flow stream.
Fixed income markets are based on economic trends going forward, not where the economy was in the past. Valuation multiples used for M&A are based not on how a target performed last year, but rather on expectations for future performance.
The implications found with forward-looking markets are immense. Two months ago, unemployment claims data suggested 16 million people had lost their jobs in just a three-week span. The stock market went on to register its strongest weekly performance in decades that particular week. This led to the following tweet from U.S. Congresswoman Alexandria Ocasio-Cortez:
Many looked at such juxtaposition as a sign of Wall Street’s corruption or brokenness - as if the market was actually applauding 16 million people losing jobs. This was not the case. Instead, since the market is forward-looking, the focus had already shifted to the May and June jobs reports. A more accurate tweet would have compared the market’s 11% down week in February with news of 16 million Americans losing their jobs in March.
2) Markets are comprised of participants with different perspectives and viewpoints. The idea that there is one person or entity determining whether equity markets move up or down on any given day is fantasy - something portrayed by the press in an attempt to add clarity to what is inherently a lot of unknown. Instead, financial markets are comprised of different viewpoints, often at odds with each other, that must come together so that price discovery can occur.
Contrary to what financial and business news publications would lead you to believe, it is impossible to know why stocks move up or down on any given day. In order to figure out why a stock is behaving a certain way, each market participant buying and selling shares of that stock would need to be questioned as to their reasoning and motive. Since such an activity isn’t feasible, it is impossible to know the reason(s) why a stock moves in a particular direction.
It may be easy to look at an S&P 500 price chart for the past few months and determine that Wall Street made one big bet around the end of March: that there would be a turn in the pandemic - a point at which the health crisis would bottom and then begin to improve, bringing with it better economic trends.
This would be an incorrect assessment of how the stock market, and Wall Street in general, operates.
There was never one large bet made by “the market” in March regarding the pandemic since there isn’t one market participant. Instead, there were millions, even tens of millions, of smaller predictions made. Some predictions were that the pandemic would just disappear. Others called for the pandemic to become increasingly bad as 2020 progressed.
The participants making these predictions considered asset prices and, using their own expectations of what may or may not happen, made a determination as to whether or not prices reflected their expectations. Exposure and risk appetites were then judged.
Another truth when it comes to the stock market’s performance over the past three months is that there was never one set of predictions guiding price action. It’s easy to think that the market is simply moving off of the same months-old mindset that existed in March, but that is faulty logic. The market is in a very different place today than it was just a month ago, or even a week ago for that matter. Predictions have been constantly evolving, both to the upside and downside, as new information comes to light.
Consider the following noteworthy events that occurred since the stock market bottomed in March:
End of March. It became clear that U.S. policymakers on both sides of the aisle were going to respond to the economic impact from the pandemic in a very big way.
Early April. After a shaky few weeks, fixed income markets returned to stability due, in part, to unprecedented commitments from the U.S. Fed. A wave of bankruptcies hitting major corporations that had seemed likely just a few weeks prior to this time was not going to materialize.
Mid to Late April. The 1Q20 earnings season was characterized by management commentary being more upbeat than analyst expectations. It also became clear that the pandemic was going to impact some industries more than others.
May and early June. The coronavirus epicenter in the U.S. (the NYC metro area) saw a complete turnaround on the health front with clear improvement in most coronavirus-related trends.
Early June. A surprisingly strong May jobs report reflected the positive impact from government stimulus programs and states beginning to reopen.
Market participants had plenty of opportunities to test their predictions made in March with the preceding developments and adjust viewpoints accordingly.
Business of Predicting Turns
Since the market is always forward-looking, the inherent nature of Wall Street is to be in the business of predicting turns - assessing when good economic times will turn sour and when bad economic times will turn positive. This practice was not unique to the pandemic.
Sometimes the collective nature of Wall Street’s predictions ends up being wrong. In late 2018, fears of the U.S. falling into a recession didn’t materialize. Back in late February, predictions that the pandemic would be quickly contained and not lead to major economic interruptions obviously ended up being wrong.
If consensus is wrong on a prediction turn, asset prices adjust and Wall Street participants regroup to make yet another prediction about a potential turn.
Apple as Example
This turn predicting occurs not only at the stock index level, but also at an individual company level. We can use Apple as an example.
Back in February, some market participants bet Apple would find itself in major trouble as the pandemic would impact both supply and demand. However, there were other market participants betting that Apple wasn’t going to suffer much on the supply side and demand would simply be delayed into the second half of 2020 and 2021.
How can such different viewpoints exist for the same company? It all comes down to how Apple is viewed. Looking at Apple as just an iPhone maker will lead to different predictions than will viewing Apple as a toolmaker with a billion engaged users who aren’t likely to go elsewhere for computing tools. This is often why commentary from those who don’t know much about Apple is prone to error. It may be easy and tempting to think that iPhone users will choose less expensive alternatives during a recession. However, one will be more accurate looking at the situation in terms of ecosystems and iPhone users not having much desire or incentive to leave Apple’s ecosystem.
Apple’s FY2Q20 earnings at the end of April marked a turning point as management disclosed that recent trends reflected demand improving “across the board.” A logical explanation was that government stimulus programs were starting to hit while product categories like the Mac and iPad were actually seeing improved results from developments like distance learning and people working from home.
Lessons
Is there a way to get ahead of Wall Street’s nature of predicting turns? Knowledge is power when it comes to achieving proper perspective. Less time should be given to topics like where markets may be headed or what is driving markets up and down on any given day. Both topics are bound to be guided by entertainment-led directives. Instead, time and attention should be given to people with unique perspectives that are able to analyze news events separately from daily stock price moves. These perspectives come from experts relying on years of experience in their respective field which allows historical context to be added to the news.
Caution is needed when determining where to turn for financial market news. I stopped watching CNBC during the pandemic because of inadequate coverage.
At the end of February, CNBC invited Jeremy Siegel, professor of finance at the University of Pennsylvania, to talk about the collapsing stock market at the time. Siegel, a CNBC regular, discussed how the vast majority of a stock price is not derived by earnings over the next 12 months, but instead by cash flow further out.
As shown in the video below, Siegel didn’t make a direct short-term call on either the market or the pandemic. Instead, Siegel was trying to add some calm to a market that was increasingly getting out of hand. The CNBC hosts didn’t want anything to do with Siegel’s comments.
Each of the hosts’ initial responses were to go after Siegel’s remarks and try to get him to say something more hysterical. The exchange was just one example of what ended up being weeks of fear-led coverage based on whatever the tone of the news was that morning. One day the end of the world was near, and the next day a random vaccine trial meant the market was undervalued by 30%.
Looking ahead, there isn’t going to be much change in the way financial markets are covered unless there is a fundamental change in business models. Finance news publications and outlets that are ultimately based on advertising will continue to being incentivized to get as many people as possible to click articles and watch videos. Said another way, financial news outlets will continue to do better when markets are in turmoil.
A Turn in the Pandemic?
This brings us back to the original question: Did Wall Street get the pandemic right?
While some market participants will be quick to say that their own (rosy) projections about the pandemic ended up right, the truth is that the situation was much more complicated.
My thinking is that most people probably haven’t changed their viewpoints regarding the pandemic over the past two months. Those who tended to be on the optimistic side of the spectrum remain optimistic. Those who were pessimistic, remain just as pessimistic. There is still a wide spectrum of viewpoints in this market regarding how the pandemic will trend for the rest of 2020.
What can explain the market’s strong performance over the past two months?
There were a number of factors that came together to impact equities. However, one of the more glaring changes was that calmness entered the market. The Chicago Board Options Exchange’s CBOE Volatility Index, known as simply the VIX, is commonly referred to as the market’s fear gauge. It measures the expected or future volatility of the market based on S&P index options. The higher the VIX, the greater the level of fear. The VIX has collapsed over the past three months (although it remains elevated).
In February and early March, the market saw the most volatile price action it has seen since the 1987 crash. Simply put, humans don’t react well to that kind of volatility. Over the subsequent three months, the news flow has in many ways allowed a level of calm to return to the markets.
Not having debt markets implode will have a material impact on one’s view on equities.
Having some of the largest companies in the world talk about a bottoming in demand in April will get attention.
Signs of improvement in the employment situation due to stimulus programs and states reopening won’t go unnoticed.
All of those developments amount to stability reentering the market. One can still have a negative viewpoint of the health impact arising from the pandemic. But when it comes to transcribing that viewpoint into thoughts about asset prices and equity valuations, emotion inevitably plays a major role.
Predicting turns on Wall Street ends up being about predicting when calmness will enter and leave the market - when market participants will be guided more by emotions and feelings or numbers and facts. Given the way humans behave, we can have a high degree of confidence there will be plenty of future turns to predict on Wall Street. In some ways, that’s why Wall Street exists in the first place - for there to be a marketplace where the economic and financial ups and downs associated with human emotion can be allowed to play themselves out.
Listen to the corresponding Above Avalon podcast episode for this article here.
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