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S&P500 Rallies, however is further Risk Aversion Ahead

May 28, 2020 By Mircea Vasiu

The US stock market staged an impressive rally from the coronavirus lows – it is now up 38% from the levels seen in March. As the S&P500 rallied past the 3000 level despite high unemployment, state aid, and a rise in bankruptcies (e.g., Hertz), many investors argue that the stock market is disconnected from reality.

Behavioral finance studies tell us that investors react differently to similar situations. The same is valid for the broad market indices like the S&P500.

S&P500 vs. Median Stocks

An interesting comparison of the S&P500 and the median US stocks shows the latter has moved little over the last twenty-three years. For investors, this can mean two things – either the S&P500 is overvalued at current levels and, indeed, lost touch with reality, or the median stocks will end up profiting the most as there is ample room in positive returns in case of market rotation.

What caused such a decoupling for the S&P500, and, more importantly – can it continue? A quick look at the detrended mean-regression for the broad market index reveals that prior to the coronavirus crisis when the index posted around 3400, the standard deviation was 1.5 from the mean. More exactly, it suggests that the large-cap stocks will end up earning low single-digit returns.

However the pandemic changed the macroeconomic picture in a dramatic way. The resilience of equity markets in light of the coronavirus pandemic is best explained by the ever changing monetary policy.

As it turns out, monetary policy conditions are at their most accommodative setting on record – far exceeding the conditions after the 2008-2009 Global Financial Crisis when the Fed set the stage for Quantitative Easing.

Moreover, analysts now expect that the growth rates for earnings for the S&P tech sector to beat the broad market by the largest margin in the last 16 years. If that is not enough, consider that tech, together with healthcare and financials, makes 60% of S&P500 forward twelve months earnings.

The conclusion is that investors’ decision changes as market conditions change. What seemed overvalued three months ago, suddenly looks different due to central banking’s active role and the perspectives brought by the new normal post the pandemic.

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