The rhetoric repeated frequently and loudly in the marketplace lately is that stocks "just want to go higher". This highlights the leading role played by market technicals, or what I think of as determining the path of least resistance for risk appetites.
Fuelled most recently by the robust involvement of retail investors, these technicals first turbocharged a rally triggered both by corporate and economic fundamentals that were better than expected and consistently supportive monetary policies. Then they were instrumental in brushing off one new troubling question after another about these same fundamentals. Finally, they helped tip a stalemate between fundamentals and policies in favour of already-elevated stock valuations. But this is becoming a heavier burden, especially as more of a spotlight is placed on their dynamics.
The three main US stock indexes have rallied 39 per cent to 45 per cent from their lows on March 23. In the process, the S&P 500 is almost back to flat for the year (down 4 per cent), outperforming the all-world index in the process. The Nasdaq has done a lot better, returning 11 per cent year-to-date, while the Dow is down more than 9 per cent.
There have been several phases to the impressive stock market rebound from the March low.
Slightly less negative health indicators – that is, a rate of worsening in Covid-19 illness that started to defy worst-case scenarios – and, initially more important, huge fiscal and monetary policy interventions, helped sharply reverse the typical liquidity-exaggerated slump that tends to take place when asset prices hit a sudden big air pocket. The upward move in prices was strengthened by additional US Federal Reserve support that, in a surprising move, went as far as the once-unthinkable purchasing of junk bonds.
The resulting spike attracted the attention and, more important, greater involvement of retail investors. They emphasised individual stocks that had notably lagged in the initial phases of the rally, a decision that was quickly validated by the boost given to "reopening" stocks powered by initial indications that the relaxation of the economic lockdowns in China and then Europe and the US were proceeding in a healthy manner.
Having endured economically devastating lockdowns to save lives, people were seeing it was possible to improve economic livelihoods while continuing to save lives. In this new "living with Covid" phase, stores were reopening and households were re-engaging in the economy while, simultaneously, rates of infection, hospitalisation and death were all continuing to improve.
Supported by a deep faith in the constant backing of central bank liquidity, the self-reinforcing upward price momentum that followed allowed stocks to overcome the next phase of less encouraging news. This included indications that the initial sharp recovery in economic activity was moderating, as was the improvement in health metrics.
Meanwhile, a rise in corporate bankruptcies was making the ugly reality of permanent capital impairment more apparent for a subset of investors. In all this, the impact of retail investor flows also proved strong enough to offset what has become greater scepticism on the part of institutional and hedge fund investors.
The underlying and evolving tug-of-war between more muted fundamentals and extremely supportive policies was in evidence last week. On the one side, the more uncertain outlook for corporate and economic fundamentals was illustrated by Apple's decision to re-close stores in two states hit by rising Covid-19 hospitalisations and record daily infection numbers. On the other side, all four systemically important central banks – namely, the Fed, European Central Bank, Bank of England and Bank of Japan – continued to make statements and take actions that show a seemingly infinite willingness and ability to pump exceptional liquidity into the system despite growing concerns about excessive risk-taking by both debtors and investors, moral hazard, excessive decoupling of Wall Street from Main Street and other unintended adverse consequences.
In the first part of last week, retail-led technicals were sufficient to resolve this tug-of-war in favour of even higher stock prices. Afterwards, markets essentially stagnated, with rising intraday volatility posing more urgent questions as to whether the headwinds were starting to become more problematic.
Such headwinds go beyond indications that China and the US, first- and second-phase Covid countries, are slipping in their ability to decisively contain the initial virus shock – China has decided to re-close schools and impose targeted lockdowns in Beijing, and some US states are reporting elevated infection and hospitalisation numbers. They also involve US economic data, such as last Thursday's new and continuing jobless claims, which have switched from constituting upside surprises for markets to downside ones.
With a lot more interest in how retail investors are allocating their money, including through increasingly analysed Robinhood data, there is greater awareness not just of what has gone well, including articles about how retail has outperformed both institutional and hedge fund investing, but also what has gone badly, such as the experience with Hertz, the US car-rental company.
The influence of retail investors' money is now experiencing what is familiar to long-distance runners who start with a sprint. The initial gains seem relatively easy and enormously satisfying, serving to build self-confidence. But as the realities of the longer distance gradually impose themselves, there is need for a second bout of energy to maintain the outperformance.
The second bout of energy for retail investors can either come internally, from more money being redirected to stocks, or externally, from an improvement in fundamentals while policies remain supportive, or both. Absent that, this notable technical momentum will fade back into the pack, requiring ever more distortional policy support over time until fundamentals improve in a durable and inclusive fashion.
Mohamed El-Erian is a Bloomberg Opinion columnist. He is the chief economic adviser at Allianz, the parent company of Pimco, where he served as chief executive and co-chief information officer.
