The most widely-watched measure of the health of the US stock market passed an important milestone this week. The S&P500 index closed at 3,390, four points above its February peak, the previous all-time high.

For many people, this will be incomprehensible. First, the medical crisis is far from over - indeed in some parts of the world it is flaring up again. Second, the economic crisis it has triggered is barely getting into its stride. Here in the UK, the end of the government’s furlough scheme in a couple of months’ time threatens the worst unemployment since the 1980s.

This hardly looks like a supportive backdrop for the resumption of one of the longest-ever bull markets. Investors’ optimism is surely misplaced.

As ever, in investment, the numbers tell a story but only a partial one. We are used to noting that the UK stock market is a poor guide to the health of the British economy.  But this is also true in America.

While it is the case that the S&P500 has regained all of the ground lost since the market bottomed in late March, this is only true at the aggregate level. Around 60% of the shares in that index remain below their previous high and the average price is 7% down from that high-water mark.

By definition that means that some shares have done exceptionally well since March, and we know that this is the case. Technology stocks, which are perceived to be the principal winners from the pandemic, have risen well above their previous highs.
Apple, for example, peaked at $325 a share in February. Yesterday it closed at $462. Amazon reached $2,170 a share at the previous peak. This week is was $3,312.

The five biggest stocks in the S&P500, all technology stocks (Microsoft, Amazon, Apple, Alphabet and Facebook), account for a quarter of the whole rise in the benchmark since the bottom. The five companies represent a fifth of the value of the index by themselves.

So, one explanation for the S&P500’s rise is that it is not really an index of the US stock market but one high-performing corner of it. Take a look at the Russell 2000 index of smaller US stocks and this is well illustrated - in February this index peaked at 1,696. Today it is 1,568.

Another explanation for the return in the index to its pre-pandemic high is the different time-horizons of the economy and the stock market. While economists are concerned with what will happen over the next few months or possibly a handful of years, investors should really be concerned with the earnings potential of companies far out into the infinite future.

Clearly the profits that a company will make in the next five years carry a bigger weight (and are more easily forecast) than those it will make in 20 years’ time. But all of those future profits need to be taken into account when deciding on the right value of a share today.

This means that a short, sharp decline in profits followed by a quick recovery can make a surprisingly small difference to the long-term value of a share. If this is the market’s expectation, then it follows that in the short term there might be an apparent disconnect between the immediate outlook and investors’ assessment of the correct price for the share.

Goldman Sachs recently issued a note pointing to some of the reasons why today’s market level might be more justifiable than many people think. The speed of recovery was a key part of its argument. Others included the possibility that an earlier-than-expected vaccine might solve the medical crisis more quickly than currently predicted. Another is our better understanding of the pandemic and the role that cheap and simple preventive measures like wearing masks might have - they make the re-imposition of costly lockdowns less likely.

A further justification for today’s stock market levels is the extraordinary stimulus that has been provided by both governments and central banks since February. It is no coincidence that the US stock market hit its low point this year on the day that the Federal Reserve announced its intention to purchase corporate bonds in an unprecedented bid to support financial markets by reducing the cost of borrowing for companies and reducing the likelihood that they would be dragged under by the pandemic.

Looking back at similar crises, all the way back to the Great Depression, it is now clear that massive financial interventions are a key part of an effective policy response. The failure to do this in the 1930s had far-reaching consequences for the US economy and its stock market and prolonged the agony of the Depression for much longer than was probably necessary.

Suppressing bond yields with this kind of massive monetary response means that shares, while relatively expensive when viewed against company profits, can seem more reasonably priced when measured against the principal alternative homes for an investor’s money. Indeed, shares are no more expensive than the long-run average when placed up against bonds.

None of this makes investing during a pandemic-fuelled recession any easier. It will feel difficult to be putting your money to work when the headlines continue to be so pessimistic. But it may be a little reassuring to realise that there is some method in the market’s apparent madness.

Knowing where to invest in these circumstances is difficult, however. As we have seen, some investments have done extraordinarily well, while others have lagged far behind. Picking the winners and avoiding the losers is a challenge and one that is probably impossible to do consistently.

A better approach is to remain well-diversified, across different assets, geographies and sectors. And to keep putting money to work in a systematic, regular fashion to ensure that at least some is invested during the inevitable dips.

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Five year performance

(%) As at 18 Aug

2015-2016

2016-2017

2017-2018

2018-2019

2019-2020

S&P 500

26.0

15.2

20.2

7.9

9.3


Past performance is not a reliable indicator of future returns

Source: FE, S&P total returns as at 18.8.20, in local currency


Important information

The value of investments and the income from them, can go down as well as up, so you may get back less than you invest. Investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.