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Don’t Be Fooled by the Stock Market’s Rally. Smart Money is Staying on the Sidelines

Last Updated September 23, 2020 1:49 PM
Laura Hoy
Last Updated September 23, 2020 1:49 PM
  • Economic warnings are growing louder, but the Dow seems oblivious to the crisis at hand
  • Irrational optimism is driving this rally, and smart money has stayed on the sidelines.
  • As lockdowns persist and the economic restart proves slower than expected, the market will likely react.

The Dow Jones Industrial Average continued to climb on Tuesday as investors cheered a potential reopening of the U.S. economy and earnings season kicked off. But mounting evidence that this rally is premature suggests the stock market could be in for a crash landing over the next few weeks.

On Tuesday, the International Monetary Fund (IMF) said it’s expecting the financial crisis caused by coronavirus to rival that of the Great Depression. The organization is expecting the global economy to shrink by 3% this year . 

In 2021, the IMF believes a partial recovery will begin, but that GDP will likely remain below pre-crisis levels: 

A partial recovery is projected for 2021, with above trend growth rates, but the level of GDP will remain below the pre-virus trend, with considerable uncertainty about the strength of the rebound.

The IMF’s stark warning echos a chorus of other calls for caution as the economic impact of coronavirus continues to deepen.

The World Trade Organization is expecting to see a 13-23% contraction in worldwide trade and the Organization for Economic Coordination and Development warned that the economic downturn would be lasting . 

Why is the Dow Still Soaring?

The only explanation for the Dow’s apparent immunity to the worsening economic data is a perceived V-shaped recovery. The stock market is still betting on a short, deep downturn followed by a sharp recovery. 

Sooner or later, this exuberant rally is going to come back down to earth as reality sets in—we’re in this for the long haul.

Whether the U.S. starts to open up parts of its economy in May or not, consumer activity is unlikely to return to normal levels for at least a few years.

That’s because even if the economy reopens, in the absence of a vaccine the public will still have to adhere to social distancing guidelines. It’s also because the sky-high unemployment figures we’ve been seeing will persist.

Many of the lost jobs reported over the past few weeks came from sectors that aren’t expected to return to normalcy for at least a year, if not more. 

Plus, reopening in the absence of a vaccine is likely to prompt future waves of lockdowns. This weekend, the Federal Reserve’s Neel Kashkari said as much in an interview with CBS.

Kashari expects 18 months worth of rolling shutdowns. Morgan Stanley agreed in an analysis that said a best-case scenario would be intermittent shutdowns over the next year. 

FAANGs Show Irrational Stock Market Trading

At some point, the stock market will react to the prolonged economic weakness. The Dow’s continued rise is irrational, especially when you look at how particular stocks are faring.

While the wider market paints the picture of a strong, V-shaped recovery, the FAANGs tell a different story. The NYSE FAANG+ index is up nearly 2% this year despite the coronavirus crash, as big names like Netflix and Amazon see increased demand amid lockdowns. 

FAANGs, Stock market crash, the dow
The performance of the FAANGs suggests traders see lockdowns persisting. | Source: Google 

There’s no debate that in a lockdown scenario companies like Amazon and Netflix are clear winners.

Netflix’s stock chart illustrates this point perfectly. Before the pandemic hit, investors were worried about Netflix’s ability to compete as more streaming services came online. 

Netflix stock, NFLX stock, the dow
Netflix stock’s meteoric rise illustrates how irrational the dow’s rally has been |Source: Yahoo Finance 

Netflix had been vastly underperforming the wider market for almost eight months when coronavirus hit. Now the stock is a market darling up a whopping 22% so far this year. The stock performance is a clear indicator that investors are betting on prolonged shutdowns.

Upside Limited as Big Money Stays Out

Nomura Holdings’ Masanari Takada noted that the Fed’s unprecedented intervention likely has a lot to do with the stock market’s stability. He noted that the so-called big money controlled by hedge funds and long-term investors will likely remain sidelined  for “some time.”

DM economic indicators continue to fall short of expectations, and government economic policies are causing quite a bit of noise. We therefore think a basic approach to short-term DM equity trading should view this as a mere spontaneous technical rebound

the dow, stock market crash
Cash positions near all time highs and extreme levels of pessimism suggest smart money is waiting out the Dow’s false-hope rally. | Source: Bloomberg 

A Bank of America investor survey confirms Takada’s point of view. The data showed that investors’ cash positions have risen to their highest levels since 9/11  as pessimism rose to an “extreme” level.

Ninety-three percent of the fund managers surveyed said they’re expecting to see a recession in the next 12 months, while only 15% said they see the V-shape path materializing.

Disclaimer: The opinions expressed in this article do not necessarily reflect the views of CCN.com. The above should not be considered investment advice from CCN.com.