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The S&P 500 is one of the most widely followed indices in the world and is seen as a key barometer for the US economy. However, following the initial shock coronavirus caused worldwide, this index’s rally and its strong message of optimism did not make sense given the dire economic outlook the US was predicted to face. In this article I will look at the reasons for the apparent disconnect between financial markets and the economic outlook, and consider whether these factors are unique to the S&P 500 or depend on other macroeconomic and political uncertainties.
Will the reasons for the current dislocation endure or is it simply a matter of time before coronavirus overpowers the bull market?
What is the S&P 500?
The S&P 500 is an index which consists of the United States’ 500 largest publicly traded companies. Each stock in the index is weighted by the company’s market capitalisation, which is calculated by multiplying the number of outstanding shares by its current stock price. It is seen by investors as a strong representation of the US’ largest companies’ performance . For this article, I will be analysing the performance of the S&P 500 from 23rd March to 15th June.
The S&P 500 and coronavirus
As markets are considered to be forward looking, when the coronavirus pandemic began, commentators looked to the S&P 500 to gain insight on Wall Street investors’ outlook for the economy. On March 23rd, the pandemic’s reality finally hit, when many countries were either implementing or already under lockdown. The index fell 34% compared to a month before, to a low of 2,237.40. Initially it seemed we were entering a bear market, which was expected given the shocking economic predictions. For example, forecasts suggested a tripling of unemployment claims and a 24% contraction of GDP between April and June . For these reasons, many investors did not anticipate the S&P’s rally since then which has not priced in the economic damage and uncertainty the US is set to face for several years to come .
Factors contributing to the rally
1. COMPOSITION OF THE INDEX
The index is cap weighted, so the larger a company’s market capitalisation, the greater impact it has on the index’s price. We can see the index weighting as a measure of each industry’s influence on the S&P 500’s price. The two industries which have contributed the most to this rally are technology, with a 26% index weighting and health care, with 15% .
US technology stocks have been seen worldwide as the ‘winners’ in this pandemic. However, even before coronavirus, investors recognised the dominance of this sector within the index, as it was often claimed ‘The S&P 500 is really the S&P 5’ . These five stocks (Apple, Amazon, Microsoft, Alphabet and Facebook) accounted for approximately 20% of the index’s entire market value, the highest proportion since the 2000 ‘dot com bubble’ when technology stocks experienced similar success in the stock market. Pre-covid, this would be a sign of risk to investors, as reliance on a particular sector does not create a diversified portfolio.
However, coronavirus has only served to consolidate the success of these companies as they have spearheaded trends such as working from home, online shopping and Netflix ‘binging’. For example, Amazon was a lifeline to consumers looking to buy essentials during hoard buying. Microsoft Teams aided our transition to home working with 75m people using the ‘Teams’ app in a single day in April .
WILL THIS TREND CONTINUE?
This pandemic has accelerated a long-term trend of technology playing a greater role in society. A recent Fortune 500 CEO survey found that 75% of companies plan to increase technology spending in the future, which will add to the valuations and earnings potential of these tech giants whilst also increasing the sector’s weighting . This suggests that technology’s dominance in the index, and its positive contribution to the S&P’s valuation will be sustained.
On the other hand, proposed international taxation laws may compromise these companies’ future earnings. The US are currently threatening to impose tariffs on European countries seeking to levy new taxes on their tech giants. Whilst discussions have reached an ‘impasse’ for now, if taxes are imposed, technology’s weighting could fall from the current 25% . The outcome of tariffs being imposed is also dependent on political tactics. Given his reaction to previous ‘tech taxes’ threatened by France, if Trump is re-elected Europe may not want to risk hostile international relations over this issue. For example, following Trump’s reaction, Macron instead promised ‘an agreement to avoid tariff escalation’ by the end of 2020 .
The second largest sector in the S&P 500 which has been a key contributor to this rally is healthcare. Key high performing stocks in this index include Johnson & Johnson, United Health, Merck and Pfizer. Companies have seen revenue and earnings growth from pausing operations and switching production to high demand PPE (personal protective equipment). For example, Eli Lilly has seen $250m extra sales in the first quarter as a result of PPE stockpiling due to the pandemic which added $18.8bn to its market capitalisation within the index . This has boosted many large US healthcare companies’ stock prices and thus their valuations within the index.
Another large driver of these companies’ stock price arose from investors betting on potential treatments or Covid vaccines. CNBC’s Covid-19 Index, which tracks 29 companies developing these treatments, including dominant health care stocks such as Johnson & Johnson has approximately mirrored the S&P’s movements. This highlights how instrumental the anticipation of a vaccine has been in spurring the rally .
WILL THIS TREND CONTINUE?
It is clear that once a reliable vaccine is available, if this is found by a US company the rise in its share price will be unprecedented and it will initiate a further rally in the S&P 500 due to a bolstering in investor confidence. However, following this, companies without successful treatments will go back to their original production and it is likely their current success in the stock market will not continue. Therefore, the timing of a vaccine is crucial for the valuation of the US health care industry and thus the S&P’s value.
2. MONETARY AND FISCAL STIMULUS
Another reason for the market rally is the huge package of monetary and fiscal stimulus introduced by the Federal Reserve and US government. Since 3rd March, the Federal Reserve cut interest rates by 1.5% and created an open-ended QE policy following March 23rd . An adequate policy response is key for a bullish market because it assures investors that policymakers are committed to adopting a stance of ‘whatever it takes’ to ensure a rapid economic recovery. By supporting businesses and consumers this reduces the threat of firms becoming insolvent, a significant risk to equity investors who subsequently cannot recover invested funds. Creating a Federal ‘backstop’ against this scenario encouraged investors to put their money into higher risk stocks in industries that have suffered financially during the pandemic .
We have seen the power of the Fed’s actions over investors when this rally experienced a blip on 15th June, as news hit of a coronavirus second wave in the US and China. Once the Federal Reserve announced the same day that it would start buying corporate bonds to give companies greater access to cash and credit, this caused a rapid rebound .
WILL THIS TREND CONTINUE?
For now, the Federal Reserve are maintaining their ‘dovish’ stance and thus preventing any large sell offs as investors begin to consider the possibility of a second spike. Although policymakers can attempt to bridge the gap between lockdown and a reopening of the economy, coronavirus will ultimately determine the shape of the economic recovery. Michael Mackenzie from the FT aptly stated ‘all the liquidity in the world only works up to a point when the fundamental outlook remains a guessing game’ .
3. INVESTOR SENTIMENT
The fact an initial sell off did not occur until March 23rd, given the virus had been in the news since December highlights how reluctant investors were to accept the scale of the economic crisis.
The Federal Reserve’s cutting of interest rates has created historically low yields for alternative investments to equities, such as in bonds or saving funds. This has given rise to the ‘Tina Effect’ (There is no alternative), where the stock market rallies because investors are forced to put a larger proportion of funds into equities to gain a worthwhile yield . Investor ‘FOMO’ (short for ‘fear of missing out’) is also evident in the stock market. In a recent Goldman Sachs report, it is stated ‘the ‘fear of missing out’ on profiting from the rally ‘best describes the thought process’ of investors rather than investing rationally .
Overall, the future performance of the S&P 500 and the economic recovery will inevitably be determined by coronavirus. A second wave is a risk to investor confidence and the valuations of less dominant industries in the index such as leisure, which are beginning to recover as lockdown is lifted. It also guides how the Federal Reserve will adapt its stimulus in the future to best ensure this recovery. As health care has such a big influence over the index’s price, a vaccine will also signal a turning point in its performance.
Although these factors have the capacity to change the market from ‘bullish’ to ‘bearish’, according to a recent survey by RBC Capital Markets the upcoming presidential election is now investors’ biggest concern. This is unsurprising when considering Trump’s influence on this index. If re-elected, his protectionist rhetoric will play a significant role in determining the outcome of the US China tensions and proposed ‘tech taxes’. Moreover, Goldman Sachs has recently outlined Biden’s suggested tax hikes and their negative impact on corporate earnings as a reason for a future bearish market . Overall, it is only a matter of time before investors realise the uncertain political and economic climate the US faces in the next few months, and eventually the S&P 500 will reflect this in its price.
First year economics student at the University of Warwick