The phrase “hindsight is 20/20” is fitting as we work our way through this pandemic. As scary and dire as things can seem, we know we will eventually get to the other side. The same can be said of markets. As we know, markets trend higher over the long run with volatility along the way. The question is, if we know this, why do people sell when faced with volatility? The reality is markets can test our patience, and often doing “nothing” is the hardest thing.

Investors want markets to “make sense” based on what we think should happen or matter. Currently with a backdrop of double digit unemployment, the worst quarterly GDP in history, and a delay in a second stimulus bill, markets continue to climb the wall of worry, and most are at or near all time highs! Add an upcoming election and this seems like a recipe for volatility—yet it has been muted for months!

Lately, it seems like regardless of good or bad economic data, markets continue to rally and are further disconnected from reality. The truth is somewhere in the middle. There are a few reasons why markets are behaving this way in the face of so much uncertainty.

Economic Data

While the economy is not back to pre-pandemic levels, much of the data has improved over the past few months:

U.S. retail sales logged their third consecutive monthly gain and largest month-over-month increase of 17.7%
The U.S. unemployment rate has dropped to ~10% from a high of ~15% in April.
The purchasing-managers index, a measure of manufacturing and services activity, rose to 54.7 from 50.3 in July, with both sectors seeing large increases.

While too soon to claim victory, steady progress is interpreted as a sign of better days ahead, and oftentimes that is all markets need. Also, we need to remember how brutal February and March were with many stocks experiencing declines of 50% to 75%, so any sliver of positive news was likely to spark a rally.

Stimulus

While economic data matters, there are periods of time where it can be overlooked. Without a massive government stimulus, we were possibly headed toward depression-level economic decline. This prompted Congress to unleash the largest stimulus bill in history with the CARES Act.

A study conducted by the University of Chicago estimated that ~68% of unemployed workers eligible for benefits could receive higher benefits from unemployment than while working. Even further, they found the estimated median replacement rate, which is the share of a worker’s original weekly salary being replaced by unemployment benefits, was 134%, one-third higher than their original wage. Combined with stimulus checks, you can see how the economy has “held up” but underlines the importance of this stimulus.

The goal is to end the stimulus once the economy is close to “normal.” The Federal Reserve has been clear with their stance on monetary policy and expect the federal funds rate to remain at zero for 1-2 years! Plus, the longer it takes Congress to pass another stimulus bill, the more likely the Federal Reserve will not only continue their dovish tone, but also provide additional stimulus which should help boost stock and bond values via asset price inflation.

By now, we know how Washington works, and it is not a question of if, but rather when, the second stimulus bill will be passed. It always seems to come down to the “last second” to get a deal done. As long as markets are convinced it will take place, it is likely that any short term weakness in the economy will be overlooked.

Overly Concentrated?

Lastly, much has been made of how the market is being propped up by the significant outperformance of a few stocks. The top five holdings in the S&P 500 (Microsoft, Apple, Amazon, Google and Facebook) comprise a whopping ~23%, which seems high but historically the top five holdings have accounted for ~12-24% of the index. What this tells me is the other 495 stocks in the index have an opportunity to play catch-up.

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