Why I cashed out of the Covid-19 rally

AN investment strategy of “Don’t just do something, sit there” has served me well over the years. So it was with some trepidation that I set it aside: As of Friday, alarmed by the recent surge of stock prices, I’m all cash.

It’s clear, of course, that stock values in the aggregate are only weakly and unpredictably tethered to facts about the economy.

History shows they’re capable of departing from reality for impressively long periods.

In terms of the fundamentals, former Federal Reserve chairman Alan Greenspan had good reason to complain of “irrational exuberance” in the US stock market at the end of 1996.

Over the next three years the S&P 500 doubled before finally collapsing in 2000. At its lowest point in 2003 it was still higher than when Greenspan issued his warning. In 1996, “sell” was good economics but terrible investment advice.

To be clear, there’s little to be said for timing the market. And yet.

The initial stock-market fall looked about right. The S&P 500 fell 34% between Feb 19 and March 23, on the first estimates of the severe economic damage that Covid-19 and the measures needed to contain it would cause.

What’s perplexing is what happened after that. Between March 23 and the end of last week, the market rose 31%, taking the index more than half of the way back to its previous high.

Over the latter period, consensus forecasts of the likely output losses due to Covid-19 in the second quarter, and for the whole of 2020 and 2021, deteriorated.

That conjunction could still be reasonable if the initial reaction had seemed, on reflection, hysterical, or if other kinds of unanticipated good news had presented themselves. But the sentiment among analysts contemplating a global slump in the past several weeks certainly hasn’t been, “Why all the fuss?” And although there has indeed been some good news – or what passes for good news these days – it gets less good on closer examination.

In response to an unprecedentedly severe collapse in output and employment, the macroeconomic-policy response has been forceful, to be sure, both on the fiscal side and from the Federal Reserve. The scale of actual and prospective support is undoubtedly a plus. But the design of the fiscal instruments is far from ideal.

The paycheque protection programme has worked badly and needs attention; the delivery of income support has been slow and patchy; the Us$600-a-week uplift to unemployment benefits will make it harder for some firms to get back to business. And the chronic dysfunction of Congress, which will surely outlast the virus, means smart answers to these problems can’t be taken for granted.

Aside from economic policy, management of the emergency continues to be something of a shambles. Tests and other essentials are still in short supply, and even now there’s no clear strategy for putting this right.

As a result, the forthcoming lifting of restrictions will be more hazardous than it should be. If the stock market thinks that plans to restart the economy over the coming days and weeks amount to a positive surprise, it might soon be having second thoughts.

According to one recent estimate, the restrictions currently in place have reduced Covid-19’s effective reproduction number in the United States to roughly 1.0 – meaning that the number of new cases and fatalities will stabilise but not fall. This implies that lifting some of the restrictions, without the means to do sufficient testing and tracing, could cause the epidemic to accelerate again. In that case, tight restrictions might need to be reimposed.

Maybe this isn’t about the next several months. Perhaps, for once, the stock market is looking past these temporary difficulties and taking a judiciously far-sighted view. (Bear with me here.)

Theories to support the idea that Covid-19 is just a blip have been proposed. The simplest was the idea of a rapid V-shaped recovery: You stop the economy briefly by government fiat and then, by easing restrictions, you bring it right back.

Who still believes this? Even if all goes well and there’s no second wave of infections, a cautious lifting of restrictions is a far cry from “normal.”

The damage is likely to drag on, and not just for a few months. For many businesses the harm will be lasting, and for some it will be terminal. Bankruptcies are sure to rise, further straining the financial system.

In addition, the recovery can’t be just a matter of supporting demand with monetary and fiscal stimulus and then throwing a switch to restart supply.

The economy will need some restructuring. Workers and resources will have to be reallocated – a difficult, costly and potentially drawn-out process. In the long term, the legacy of aggressive monetary and fiscal interventions will have to be addressed. The politics of central banking, inflamed by arguments over where monetary policy stops and fiscal policy begins, could get extremely fractious.

At some point, with public debt surging, higher taxes – maybe much higher, including on profits – will be back on the agenda. The outlook for world trade was bad before; now it’s worse.

One more thing. Bear in mind that the market wasn’t cheap even before the pandemic came along.

Yes, analysts argue endlessly about valuation measures, and the standard metrics are especially hard to read when interest rates are very low. (The Shiller cyclically-adjusted price-to-earnings ratio has been saying “sell” for at least five years.)

Still, it’s fair to say that the stock market’s current view of future earnings would look pretty optimistic even if Covid-19 had never happened. A gentle reminder: Covid-19 is in fact happening – and the new risks it has introduced are large and notably skewed, as they say, to the downside.

If you ask me, not that you should, it’s a case of really irrational exuberance.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Clive Crook is a Bloomberg Opinion columnist and writes editorials on economics, finance and politics. He was chief Washington commentator for the Financial Times, a correspondent and editor for the Economist and a senior editor at the Atlantic.

Bear in mind that the market wasn’t cheap even before the pandemic came along.