Many investors are left scratching their heads at the market’s recent performance, but let me tell you one reason why the recent rally actually makes sense.
I know you’re sick of hearing my lamentations of a surging stock market on the back of dire economic news, but you have to see it from my perspective. I’m stuck 5 days a week studying the markets, that have, to my mind, long defied logic. The phrases ‘priced-in’ and ‘forward-looking mechanism’ seem to follow me around like an annoying shadow as I try to find a reason why the S&P 500 (NYSEARCA:VOO) had its best quarter in over twenty years and the Nasdaq (NASDAQ:QQQ) is hitting all-time highs for fun now.
While it holds true that the stock market is not a representation of the economy, a chasm of this size between Wall Street and Main Street is neither desired nor tenable. Stocks surge off the back of no real news and valuations become more and more outrageous. Tesla (NASDAQ:TSLA), Shopify (NYSE:SHOP), and Square (NYSE:SQ) each hit a new all-time high this week, and while all fantastic businesses, investors have poured in en masse inflating their stock prices to extreme levels.
Elon Musk himself, a megalomaniac who may become the richest man in the world off the back of Tesla’s stock performance, complained back in May that Tesla’s stock price was “too high”. Tesla closed that day at around $700 a share, it’s now sitting at $1120 and has become the largest car manufacturer by market cap in the world.
As the U.S. economy stares down record numbers of coronavirus cases and a new round of potential shutdowns, investors should be worried. Instead, they’re piling into growth stocks. Surely this level of uncertainty should push them to safer investments, shying away from high-risk equities. Well here’s the kicker, and she goes by the name of TINA.
There Is No Alternative
The equity risk premium is an indicator used to measure the excess return in investing in the market compared to a risk-free rate, i.e. bonds. It’s a convoluted and technical metric that I will let Investopedia explain better than I ever could, but in essence, it is used to gauge whether the additional risk involved in buying stocks over bonds is worth the potential reward. With interest rates at record lows and yields on 10 Year U.S. Treasury Bonds, one of the traditional safe-havens investors and money-managers flock to in times of uncertainty, coming in at less than 1%, the equity risk premium is ticking very favorably towards equities right now.
As money managers look at the paltry yields of bonds and compare them to the targets they’re forced to hit each quarter/6 months/year, many will see no alternative but to rebalance their portfolios in favor of stocks. While the risk in equities is high right now, the inflated prices they pay for them will be worth it in many investors’ eyes. A lot of people out there may be rethinking their traditional 60-40 split of stocks and bonds in order to ensure targets are met.
The impact of this is huge. While a lot of headlines are being hogged by the new surge in retail investing, make no mistake that the vast majority of the market is made up of traditional money managers and institutional investors. The speculative day-trading antics of David Portnoy on Twitter (NYSE:TWTR), or a surge in the bankrupt Hertz (NYSE:HTZ) make a good news story, but their overall impact on the market is minimal. What really moves the needle is where the traditional money goes, and right now it’s moving away from bonds and into stocks.
Not all stocks are created equal
So now that we have institutional investors moving more money into stocks, where is it going to go? I’ve expressed my frustration about the current valuations of a lot of stocks, but unfortunately, that is the reality we’re living in today. Want to enter into the burgeoning online gambling industry? You’re going to pay over the odds for DraftKings (NASDAQ:DKNG) or Penn (NASDAQ:PENN) right now. How about e-commerce? Shopify, Paypal (NASDAQ:PYPL), Sea Limited (NYSE:SE), and even the trillion-dollar Amazon (NASDAQ:AMZN) are all looking frothy. And don’t get me started on the stay-at-home picks like Teladoc (NYSE:TDOC), Zoom (NASDAQ:ZM), Peloton (NASDAQ:PTON), or Netflix (NASDAQ:NFLX).
With all this extra capital circulating, the most attractive stocks are going to be overpriced. Expensive stocks are expensive for a reason, especially those who actually benefit from lockdown conditions. This goes a long way to explaining why we are looking at all-time highs in the middle of a recession.
MyWallSt operates a full disclosure policy. MyWallSt staff currently hold long positions in companies mentioned above. Read our full disclosure policy here.