The Dow Jones Industrial Average and S&P 500 are flirting with all-time highs. The NASDAQ Composite Index continues to shatter records. But there is a disconnect between what’s happening in the stock market and what’s happening in the U.S. economy. The markets appear to be ignoring how the coronavirus could affect valuation.
Factors Currently Moving Stock Prices
Stock prices appear to be fueled by two important drivers: optimism that a coronavirus vaccine is just around the corner and a flood of liquidity from the Federal Reserve. The profound shift in the way people are interacting with one another contributes an additional dynamic.
Family gatherings take place online, and business meetings are conducted over video conferencing applications. This phenomenon has sparked a surge in technology stocks, including shares of companies that provide these services and those that own the data, systems, and machinery the services rely on. Online retailers and streaming entertainment providers have also seen huge spikes in business.
Big technology companies are responsible for a large part of the markets’ advances. This is because the major indexes are all capitalization weighted. The bigger a company is, the more influence it has on the price of the index. And technology names represent a significant portion of the Dow, about a third of the S&P, and nearly all of NASDAQ.
But equity markets seem to be dismissing the effect of the pandemic on the economy.
The Disconnect Between Fundamentals and Stock Prices
According to the latest report by the Bureau of Economic Analysis, real gross domestic product (GDP) declined by 4.4 percent in the first quarter of 2020. At the same time, corporate profits declined by more than $482 billion.
Consumers who could make up some of those losses face the highest unemployment numbers since the Great Depression. More than 11 percent of American workers are unemployed. And there is no clear indication that things will turn around anytime soon.
During a virtual event hosted by the National Association for Business Economics, Lael Brainard, a member of the Board of Governors of the Federal Reserve told attendees that “the pandemic remains the key driver of the economy’s course,” warning that “a thick fog of uncertainty still surrounds us, and downside risks predominate.”
That downside risk to the economy could manifest as lower stock prices.
The Coronavirus Pandemic Creates a Two-Fold Problem for Stocks
The pandemic has created an uncertain environment. That alone could be enough to halt the markets’ recent advances and hasten a reversal. If there is one thing equity markets cannot long tolerate it is uncertainty. The pandemic also poses another threat to stock prices in the form of corporate earnings.
When second quarter GDP is reported later in the year the number will likely confirm current running estimates that the economy contracted by more than 35 percent in the three months ended June 30. The RAND Corporation estimates that COVID-19 mitigation efforts so far in 2020 have created a $2.8 trillion loss in aggregate U.S. national income. This could have a detrimental effect on corporate earnings.
The link between earnings and stock prices is direct and powerful. There is no greater correlation. With few exceptions, earnings determine stock price. If the pandemic prolongs or worsens the current recession, earnings will fall. This presents a significant problem for stocks currently trading as if the pandemic doesn’t exist.
Where Can Investors Turn to Protect Stock Market Gains
Investors seeking to protect recent stock market gains can look to annuities. Although these insurance products are intended to augment retirement income, they can offer modest but reliable investment portfolio growth.
By including variable annuities in a long-term diversified investment program, you can grow your investments while maintaining a measure of downside protection. Annuity providers typically guarantee contract owners a return of their premium for a variable annuity.
As a result, even if your underlying portfolio accounts fall below your contract value, a variable annuity will still return the full amount of your initial investment.
A variable annuity potentially subjects you to a zero-percent return if the portfolio loses money. However, it won’t put your principal at risk.
In an environment as uncertain as that which has been created by the coronavirus, the peace of mind an annuity can offer is a reasonable strategy for protecting recent stock market gains.
10 Cited Research Articles
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