Why the Heck is the Market Rallying (in three simple charts)… and How Should I Play This ?


  • The S&P 500 has rallied 27% from the March 23 lows
  • The fiscal and monetary stimulus has been much more rapid and significant than anything we’ve seen in prior recessions. This is a strong technical rally, and I wouldn’t fight the Fed.
  • Bear market rallies … upticks during periods of depreciating asset valuations, usually driven by short squeezes and compounded by momentum trades … have happened before. I looked at three such rallies of 20% or more (2002, 2008 and 2009), all in the teeth of a recession, and usually chasing the rally is bad in the medium term but works out OK for investors with a long term horizon

Earnings don’t move the overall market; it’s the Federal Reserve Board … focus on the central banks, and focus on the movements in liquidity … most people are looking for earnings and conventional measures. It’s liquidity that moves markets.

— Stanley Druckenmiller, Quantum Fund

Amidst the economic carnage (22 million Americans unemployed!? A 9% drop in retail sales in March … what’s going to happen in April?) that has been inflicted on the global economy, a tremendous rally is taking place in public equities. As of the close on April 17th, the S&P 500 is 27% higher than its March 23rd low.

The Americans are not alone. The UK FTSE 100 is 16% up from it’s low (also on March 23rd), and the market in London has rallied while that country’s Prime Minister has spent most of that rally in intensive care. The German DAX is up 25% from its bottom on March 18, and the Nikkei 225 is up 20% from March 21st.

What gives!?

Well, in two prior posts, I argued that this was likely a generational buying opportunity, and that the public market’s bottom was likely already in. But overall sentiment has remained very bearish among professional investors, with a lot of doubt that a stock market rally will sustain in the face of an oncoming recession.

I think a few things are happening here. First of all, the US market dropped over 34% from its peak, the kind of drop that we only see about once in a generation … it’s only happened six times since the Great Depression. And it got there faster than any other bear market on record … and by a long shot.

The rapidity with which the market has priced in reality has been (and still is) under-appreciated by most investors. Let’s reflect on just how fast the market has adjusted: the average number of days from peak to bear market territory (i.e. from an all-time high to a 20% decline) for the Dow Jones Industrial Average since 1915 is 255, the median is 156. This time, the Dow dropped 20% in just 19 sessions, from Feb. 12 to March 11. The second fastest was 1929, which took 36 sessions.

Second, the federal government has stepped in with two forms of stimulus: monetary and fiscal. In both cases the amounts are unprecedented, and I think a lot of this is just working its way through the financial markets.

I can represent this in the next three charts. First, let’s look at the size of the Fed’s balance sheet. The graph below uses data from the Fed’s own website … go to “Federal Release H.4.1 — Factors Affecting Reserve Balances.”

Chart 1: Federal Reserve Balance Sheet

This shows that the size of Fed is orders of magnitude greater than the previous QE regime. In just two weeks, the Fed has added nearly $2T of assets to its balance sheet: based on their press release from March 9th, they are buying Treasuries, commercial paper, muni’s, agencies, ABS, leveraged loans, high-yield debt (BB-rated), and old baseball cards (Topps AND Donruss).

Under their old QE regime, the Fed typically purchased $60–80B of bonds per month, so this is a full year’s worth of QE in just two weeks. They’re saying that they aren’t done yet, that they could spend another $2.3T on asset purchases.

Here is the press release from the Fed.

Just for context, in 2008, the Fed pumped $1.2T into fixed income securities … mostly Treasuries, a bit of munis, some commercial paper. The size of the Fed’s balance sheet peaked on December 17th, 2008 at just over $2T, about a third of where it’s at today.

Chart 2: Fed balance sheet — during the Great Recession

Also, for context, the entire value of the US stock market is $20T. The fixed income markets are about $45–50T. This year, total Fed potential buying will be borderline “unlimited.” With $1.5T of purchases to date, and another $2.3T potentially available to backstop fixed income asset classes, simply unfathomable quantities of capital are flooding the markets.

Much of that HAS to be spilling over from bonds into equities.

Third, the federal government is also unloading an unprecedented amount of fiscal stimulus into the economy. The projected deficit for 2020 is over 13% of GDP, which reflects an underlying deficit of 3% and an additional $2T stimulus bill that was passed on March 27. Discussions of another $1T infrastructure bill or otherwise could take these numbers even higher.

This dwarfs previous deficits from the 2010–2012 period; and with Treasury rates this time around even lower than they were in 2008 … effectively zero percent for short-dated Treasuries … expect more on the way.

Chart 3: Federal deficit

FRED Graph ObservationsFederal Reserve Economic

DataLink: https://fred.stlouisfed.orgHelp: https://fred.stlouisfed.org/help-faqEconomic Research DivisionFederal Reserve Bank of St. Louis

One more observation on why I think the stock market bottom is already in. Typically, the S&P 500 troughs just before unemployment claims peak, because by the time claims (a coincident / slightly lagging indicator), the bad financial news is already understood and the market has priced it in. The only times that this WASN’T true in the prior seven bear markets were in April 1970 (when the Fed employed a very restrictive monetary policy to quell inflation, and equities reacted before a contraction in the real economy) and in 2001.

Exhibit 1: S&P 500 trough versus unemployment claims

How Should I Play This?

I generally subscribe to the school of investment thought that says that individual investors shouldn’t try to time the market bottom, just try to buy great companies at good prices and keep investing slowly into market troughs.

Note that when the market rallied 20% off the bottom in 2008–2009, it was a clear buy signal. True, you could have waited another 3–4 months, but the fact is if you had bought around March 30, 2008, you would have been ahead by 4% in 3 months and by 38% in 12 months.

Exhibit 2: Chasing the Bear Rally, 2008–2009

2001–2002 worked quite differently. The market peaked in March 2000, then put in a false bottom about a year later in April 2001. The first rally off that bottom was a head-fake, as the buying got exhausted in the fall of 2001. The market spent most of 2002 below that first bottom. Finally, the market found a floor in March 2003, and then began a five-year bull rally.

Exhibit 3: Chasing the Bear Rally, 2000–2002

These two examples are insightful.

Had you “chased the 20%” rally in 2008/2009, and picked up the S&P index at say 925 in early January, then in a year, you would have earned 25% in returns going out to January 2010. Had you waited until the recession ended in nine months, and not purchased the index until say September 2009, then you would have only made 11%.

Looking at the 2000–2002 recession, had you chased the 20% rally, and bought stocks in March 2002, you would have lost 25% in the following year. Eventually, you would have recovered your investment, by around November 2004.

Both examples suggest that it’s Ok to wait for 3–6 months, let the recession play out, and don’t chase this tape higher.

I tend to think that this scenario will play out more like more like 2008–2009 (and that you shouldn’t wait more than 6 months), for a few reasons:

  1. The level of government intervention this time around is much greater … it was basically a non-factor in 2002, when the Fed remained more or less on the sidelines. And the federal deficit remained below 2% of GDP until 2003.
  2. The 2000 to 2002 was a long, slow bear because in large part the market had gotten overheated from 1995 to 2000. SO it took longer to unwind and find a bottom.

Look at the 30-year-trend in the price / earnings ratio. This fascinating analysis from ValueScope shows that the PE ratio (trailing) for the S&P 500 has average 19.4x going back to 1971. There have only been 5 periods when the PE ratio drifted above above the average: 1) Right before the 1987 crash (“Black Monday”); 2) right after the 1990s recession, which saw depressed earnings; 3) the 1999–2000 tech bubble, when the ratio peaked at close to 45x; 4) the 2008–2009 recession (again depressed earnings); and 5) the past 32 months.

While not cheap per se at 20x this go around, there is far less a bubble to deflate valuation-wise.

Exhibit 4: PE Ratio since 1971

Source: ValueScope

Former C-suite at PayPal, Sonos, eBay. Now general partner & founder at Practical VC, a secondary venture capital fund.

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