The Dow is rallying on negative headlines. This isn't an illogical rally since the market anticipates what's ahead. Investors think the worst is behind us.
The Labor Department reported on Friday the worst job losses since the Great Depression. But the Dow Jones continued to rally.
The pandemic and the efforts to contain it have erased at least 21.4 million jobs in the United States in just two months, including a record loss of 20.5 million jobs in April alone. The unemployment rate jumped to 14.7% in April.
The world is plunging into a deep recession after economies worldwide shut down to slow the spread of the coronavirus.
So why has the Dow — which was down by about 35% on March 23 from February high — rebounded by 30% despite awful economic numbers?
The stock market is not the economy. It is forward-looking. The Dow and other stock market indices are leading indicators of what’s going to happen in the economy.
The stock market will always predict a recovery before economic data shows it because investors set prices based on what they expect to happen, not on what is actually going on. Bear markets usually end about three to six months before recessions.
The Dow has rallied because investors think things will get better in three to six months. They believe the worst is over.
Jason Brady, CEO of Thornburg Investment Management, sums up the disconnect between negative news and the stock market rally:
If prices try to take into account the end of the world, and the end of the world is slightly less likely to happen, equities can rise.
When things are bad, even a small improvement can make investors willing to buy. Stocks start to rise when the data suggests that things are less bad. Things don’t have to be great.
While weekly initial jobless claims are still catastrophic (the latest weekly jobless claims was 3.2 million), those numbers have steadily decreased for five consecutive weeks.
While corporate earnings are shrinking, they haven’t been so bad yet. Large companies like Tesla (NASDAQ:TSLA) and Microsoft (NASDAQ:MSFT) posted better-than-expected earnings.
It looks like companies can still grow and make money during the coronavirus pandemic. Many companies don’t provide guidance, but it may not matter that much. Earnings are not as disastrous as investors were expecting so far.
The Fed’s massive stimulus also helps to support the stock market. The cut in interest rates makes stocks more attractive as bonds have meager yields.
Americans are optimistic about the reopening of the U.S. economy. More than half of the states have slowly started reopening.
Robert Johnson, chief executive of Economic Index Associates, said current stock valuations suggest investors are expecting a V-shaped post-COVID-19 recovery, with the economy returning to normal within a year.
Johnson doesn’t believe a sharp recovery is realistic:
I believe those predicting a V-shaped recovery are overly optimistic. I fear the recovery will not even be U-shaped, but that we will have a false start to a recovery, experience another economic downturn, and then slowly recover. In effect, the recovery will be W-shaped.
If the recovery is W-shaped as Johnson predicts, the Dow will crash again.
Since there is a lot of uncertainty about how long the recession will last, anything can happen. A sustainable recovery probably won’t happen until there is a vaccine.