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April 2020 was the S&P 500’s best month in over 30 years. Huh?! How is that possible?

7 May 2020

April 2020 was the S&P 500’s best month in over 30 years. (Since January 1987, to be specific.)

During that same month, tens of millions of Americans claimed unemployment benefits.

Huh?! How is that possible? Many people would (reasonably) think that state of affairs is crazy.

This sounds crazy, but it’s not as weird as it seems. One of the key things about the share market is that it will surprise you. What would be more surprising is if it didn’t give you any surprises.

Let me give two explanations for this bizarre state of affairs. I’ll start with the weakest explanation and then explain the real reason this isn’t surprising (IMHO, of course).

“The stock market isn’t the economy.”

Lots of businesses are struggling. This includes many small- to medium-sized businesses, especially those in industries like hospitality and tourism.

But we need to remember that the S&P 500 represents 500 very large publicly listed companies in America. These aren’t mum-and-pop businesses. They have resources and clout that smaller businesses don’t. It’s likely that, on average, these businesses will have better long-term prospects than other businesses.

We also need to remember that the S&P 500 is weighted by market capitalisation. This means that larger companies are more heavily weighted when looking at the value of the S&P 500. The larger companies tend to be very profitable and have large cash reserves. They are usually extremely well-positioned to weather storms like this and take advantage of opportunities.

As I write this, the five largest companies on the S&P 500 are (in order): Microsoft, Apple, Amazon, Alphabet (Google), and Facebook. At the time of writing, they make up approximately 20% of the entire value of the S&P 500. If anything, COVID-19 is likely to be good for most of these companies.

Of course, there are some big businesses that are struggling. Airlines are doing poorly. Boeing shares are valued at less than 40% of what they were worth six months ago. Air NZ shares, which were trading at nearly $3 per share six months ago, are trading at less than $1.30 as I write this. But on average, large companies are likely to be in better shape, and have better prospects, than small companies, especially those that have the heaviest weightings.

(On that note, remember the saying: when you owe someone $1 million and you can’t pay, you have a problem. But when you owe someone $100 million and you can’t pay, then it’s their problem? Well, shares in Boeing and Air NZ would probably be even lower if people thought that they weren’t going to be bailed out in one way or another.)

The sharemarket is a prediction market

It’s easy to see a major sharemarket correction as evidence that the market is irrational, or inefficient.

The best way to think of the value of an individual share is that it reflects the consensus view of many people regarding the future prospects for the company in question. The past and the present might provide an indication of how the company might go, but the real concern is its future.

Unless you have a crystal ball, the future is uncertain. We continue to get new information, which will lead us to adjust what we think the future holds.

Think of it in terms of a sports match. Let’s say the All Blacks are about to play the Wallabies. You might have some assumptions regarding which team will win. For example, before they run onto the field you might be 80% confident that the All Blacks will win. But what happens if the Wallabies snatch a couple of early tries? At 14-0 down, do you still think the All Blacks are 80% likely to win? You might be confident that the ABs will pull it back. But your odds will probably have changed: from 80% to perhaps 55%.

The same happens with the sharemarket. As new information comes to light — like, say, a pandemic that requires people to lock down — we will recalibrate your expectations.

This happened in the share market in March, in a big way. From a high in February to a low in March, the S&P 500 dropped by over 30%.

Since the low in March to the start of April, the S&P rose nearly 30% from its low, so it is now “only” 16% lower than its peak in February.

What gives?

The important thing to keep in mind is that the sharemarket represents expectations about the future.

What this means is that when the S&P plummeted in March, this represented some really bad predictions about what the future held.

The sharemarket rising doesn’t mean that bad stuff isn’t happening, or that it isn’t going to happen. Forgetting the ups and downs, we’re still 16% or so down from where we were in February, and that’s still a lot. That’s still pretty bad.

What it means is that the predictions priced into the market now suggest that expectations have improved compared to where they were a month ago.

We now know more about COVID-19. We can see how Governments and central banks around the world are reacting to current events. We see that people are, for the most part, socially distancing, and that curves are bending.

The consensus view is that we are moving from really-really-bad to really-really-bad-but-not-quite-as-bad-as-we-feared last month.

Back to the All Blacks versus the Wallabies. Perhaps we got to half time, and the Wallabies weren’t able to consolidate on their lead. They’re still at 14, and the ABs have a penalty on the board, so they are trailing by 14-3: instead of needing two converted tries to get to a draw, we can get the win with two tries and only one conversion. The odds may still not be 80%, but they may have crept up to 60% or 65%. Have faith — the boys will play a full 80 minutes and the Wallabies will run out of steam…

Will new information come to light, about the virus and our collective response? Of course it will. And before you or I can do anything about it, this new information will be priced into share prices.

The share market could go up. It could go down (and pundits will be talking about the “dead cat bounce”). There are too many factors to predict.

It’s okay to be surprised by the share market. It’d be weird if it didn’t surprise you. Just don’t be surprised when it surprises you.


Tags

prediction, predictions, s&p500, sharemarket


About the author 

Sonnie Bailey

In his spare time, Sonnie likes telling people that he’s a former Olympic power walker, a lion tamer, or that he is an orthodontist. He is none of those things. In reality, Sonnie is a financial planner based in Christchurch. Through his business, Fairhaven Wealth (www.fairhavenwealth.co.nz), he provides independent, advice-only, fixed-fee financial planning services. Sonnie is a “recovering lawyer”: he has specialised in trusts and personal client work. He has also worked as a financial services lawyer for many years.

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