The S&P 500 is regarded as one of the most widely followed indices in the world as well as being seen as a key barometer for the US economy. However, following the initial shock coronavirus caused worldwide, this index’s rally and its strong message of optimism contradicted the dire economic outlook the US was predicted to face. This article will look at the explanations for the apparent disconnect between financial markets and the economic outlook, and determine whether these factors are unique to the S&P 500 or depend on other macroeconomic and political uncertainties.
Will the reasons for the current dislocation endure or is it a matter of time before coronavirus overpowers the bull market?
The S&P 500 is an index consisting of the United States’ 500 largest publicly traded companies. Each stock in the index is weighted by the company’s market capitalisation, calculated by multiplying the number of outstanding shares by its current stock price. It is portrayed by investors as a strong representation of the US’ largest companies’ performance . For this article, I will be analysing the performance of the S&P 500 from 23rd March to 15th June.
As markets are thought to be forward looking, when the coronavirus pandemic began, commentators looked to the S&P 500 to gain insight on Wall Street investors’ outlook for the economy. On March 23rd, the pandemic’s reality finally hit, when many countries were either already in national lockdown or close to doing so. The index fell 34% compared to a month before, to a low of 2,237.40. Initially it seemed we were entering a bear market, which was no surprise given the shocking economic predictions. For example, forecasts suggested a tripling of unemployment claims and a 24% contraction of GDP between April and June . For these reasons, many investors did not anticipate the S&P’s rally since then which has not priced in the economic damage and levels of uncertainty set to face the US for several years .
Recent performance of the S&P 500
Factors contributing to the rally
COMPOSITION OF THE INDEX
The index is cap weighted, therefore the larger a company’s market capitalisation, the greater impact it has on the index’s price. We can see the index weighting as a measurement of each industry’s influence on the S&P 500’s price. The two industries that have contributed the most to this rally are technology, with a 26% index weighting and health care, with 15% .
US technology stocks have been recognised worldwide as the ‘winners’ in this pandemic. Although, even before coronavirus, investors acknowledged the dominance of this sector within the index, as it was often claimed ‘The S&P 500 is really the S&P 5’ . These five stocks (Apple, Amazon, Microsoft, Alphabet and Facebook) made up approximately 20% of the index’s entire market value, the highest proportion since the 2000 ‘dot com bubble’ when technology stocks experienced similar success in the stock market. Pre-covid, this would be seen as a risk to investors, as reliance on a particular sector does not create a diversified portfolio.
However, coronavirus has only aided the consolidation of success of these companies as they have led the way in trends such as working from home, online shopping and Netflix ‘binging’. For instance, Amazon was a lifeline to consumers looking to buy essentials during mass buying. Microsoft Teams helped smooth the transition to home working with 75m people using the ‘Teams’ app in a single day in April .
WILL THIS TREND CONTINUE?
The global pandemic has accelerated a long-term trend of technology playing a greater role in society. A recent Fortune 500 CEO survey depicted that 75% of companies plan to elevate technology spending in the future, which will add to the valuations and earnings potential of these tech giants whilst also increasing the sector’s weighting . This suggests that technology’s dominance in the index, and its positive contribution to the S&P’s valuation will be sustained.
Contrastingly, proposed international taxation laws may compromise these companies’ future earnings. The US is currently threatening to impose tariffs on European countries seeking to levy new taxes on their tech giants. Whilst discussions have reached an ‘impasse’ for now, if taxes are imposed, technology’s weighting could decrease from the current 25% . The outcome of tariffs being imposed is also dependent on political tactics.
The second largest sector in the S&P 500 which has been a key contributor to this rally is healthcare. Key high performing stocks in this index include Johnson & Johnson, United Health, Merck and Pfizer. Companies have seen revenue and earnings growth from pausing operations and switching production to high demand PPE (personal protective equipment). For instance, Eli Lilly has seen $250m extra sales in the first quarter as a result of PPE stockpiling due to the pandemic which added $18.8bn to its market capitalisation within the index . This has provided a boost to many large US healthcare companies’ stock prices and thus their valuations within the index.
Additionally, another large driver of these companies’ stock price arose from investors betting on potential treatments or Covid vaccines. CNBC’s Covid-19 Index, which tracks 29 companies developing these treatments, including dominant health care stocks such as Johnson & Johnson has approximately mirrored the S&P’s movements. This highlights how instrumental the anticipation of a vaccine has been in spurring the rally .
CNBC Covid-19 Index
MONETARY AND FISCAL STIMULUS
Another reason for the market rally is the monstrous package of monetary and fiscal stimulus introduced by the Federal Reserve and US government. Since 3rd March, the Federal Reserve cut interest rates by 1.5% and created an open-ended QE policy following March 23rd . An adequate policy response is key for a bullish market because it assures investors that policymakers are committed to adopting a stance of ‘whatever it takes’ to ensure a rapid economic recovery. By supporting businesses and consumers this lowers the threat of firms becoming insolvent, a significant risk factor to equity investors who subsequently cannot recover invested funds. Creating a Federal ‘backstop’ against this scenario encouraged investors to put their money into higher risk stocks in industries that have suffered financially during the pandemic .
We have seen the power of the Fed’s actions over investors when this rally experienced a blip on 15th June, as news hit of a coronavirus second wave in the US and China. Once the Federal Reserve announced the same day that it would start buying corporate bonds to give companies greater access to cash and credit, this caused a rapid rebound .
The fact an initial sell off did not occur until March 23rd, given the virus had been prevalent in the news since December highlights the reluctance of investors to accept the scale of the economic crisis.
The Federal Reserve’s cutting of interest rates has created historically low yields for alternative investments to equities, such as in bonds or saving funds. This has given rise to the ‘Tina Effect’ (There is no alternative), where the stock market rallies because investors are forced to put a larger proportion of funds into equities to gain a worthwhile yield . Trader ‘FOMO’ (short for ‘fear of missing out’) is also evident in the market. In a recent Goldman Sachs report, it is stated ‘the ‘fear of missing out’ on profiting from the rally ‘best describes the thought process’ of investors rather than investing rationally .
Overall, the future performance of the S&P 500 and the economic recovery will inevitably be determined by coronavirus. Subsequent waves are a risk to investor confidence and the valuations of less dominant industries in the index such as leisure, which are beginning to recover as lockdown is lifted. It also guides how the Federal Reserve will adapt its stimulus in the future to best ensure this recovery. As health care has such a drastic influence over the index’s price, vaccine rollout will also signal a turning point in its performance. Overall, it remains to be seen how a new presidential elect and recovery from a global pandemic will precisely impact investors and how the S&P 500 will reflect this in its price.