What now for indices after the sell-off?

Is the new market slump here?

Markets take the stairs up but the lift down. That is the classic market cliché that perfectly describes the last month in US indices. Steady gains (or not so steady, in the case of the Nasdaq) were followed up by a swift and brutal fall that saw triple-digit losses for the S&P 500, while the Dow plunged 1000 points.

After months of gains, and with an economic recovery that looks like it is stalling, investors will be asking, ‘is that it?’. Has the rally come to an end, and is the next big leg down upon us?

Of course, without a crystal ball it is impossible to tell (if anyone knows where I can get one please say). There are arguments on both sides, which we will look at below.

The bear case

It is not hard to find reasons to worry about the global economy. The Covid-19 pandemic continues to rage, and is likely to be around until a vaccine is found. While economies are slowly reopening, reports of further outbreaks remind us that the crisis is not yet over.

After an initial rebound in economic data, the recovery has begun to slow down. Key measures such as monthly US payrolls and credit card spending have flattened out, and while Q3 GDP data is expected to be one of the best on record, this is more of a reaction to how awful Q2’s was than any indication of a sudden rebound in global economic activity over the longer term.

Stocks also look expensive, particularly in the US. The high valuations currently on offer look particularly high when set against the dull economic outlook. If earnings continue to weaken then the case for holding equities will be weakened too. A more defensive tone will come into play, with utilities and consumer staples favoured over the high-growth plays like technology.

Investors should also be wary of the US election. US stocks in particular do weaken ahead of elections on average, as investors choose to wait for polling day to pass before moving back into stocks. This year seems to require even more caution, since a tight race and uncertain result raises the prospect of continued uncertainty beyond early November, in a manner reminiscent but perhaps worse than that of 2000 and the Bush vs Gore election.

The bull case

Not every pullback is the beginning of another major selloff. Every bear market has to begin somewhere but attempting to pick tops in a bull market is a surefire method of losing money.

While Covid-19 is still with us, it is now a ‘known known’. The market reacted so dramatically in February because no one expected a global pandemic. Now the virus is well known, and even if new lockdowns are ordered the focus will be more on the economic effects and not on the possible infection count and eventual death toll.

Economies are beginning to see their recoveries slow down, but the huge rebound of Q3 was always likely to moderate. The key will be the direction of travel, and with huge fiscal and monetary stimulus the global economy is likely to recover, even if it takes a while. The big fear is a rise in unemployment, and this is the major flaw in the bull case. Governments will have to step in with further support if necessary, and markets may suffer increased volatility while this is sorted.

Fund managers are still underweight equities as well. The rebound caught many by surprise, and disbelief mounted in unison with the rally in US stock markets. Now many will find it necessary to slowly increase their allocations to equities, providing further fuel for the rally.

The huge gains in tech stocks this year have brought parallels with 2000. But this is not the dot-com boom of twenty years ago. Firms like Facebook, Amazon and Apple are not untried tech firms with no income. Now they are global titans with huge cash revenues, with plenty of potential for further growth. They are more deserving of the high valuations currently seen than any of the earlier tech darlings were. Indeed, in a market where growth is the most important quality their high levels of cash generation and continued robust sales growth will command higher valuations, not lower.

Finally, there is the matter of yield. In a world of negative real interest rates and super-low corporate bond yields, equities offer the only real choice of income for many investors. This means that dips will continue to be bought, even dramatic ones like that of February and March. The need to find income will keep driving investors into equities even as they keep rising.

Long-term outlook still promising

The Covid-19 crisis is likely to pass eventually. Central banks and governments will continue to provide supportive policies. Consumer spending will recover. Even the US election will eventually fade into the background. The market weathered the initial storm of Covid-19, eventually. It seems like further gains into 2021 and beyond are likely, but after the easy summer of 2020 for equities, a tougher Autumn may lie ahead.