Don’t Read Too Much Into Stocks’ Sudden Rebound

It’s hard to believe, but in just more than a month, U.S. stocks, as measured by the Dow Jones Industrial Average, a widely followed albeit partial and imperfect proxy, have gone from a record high to the fastest correction in history to the best week since 1938. Driving these moves to a great extent were the contrasting investor sentiments of complacency at first and then panic. If you can correctly characterize the week’s strong rally, you hold the key to what lies ahead.

The Dow hit its record on Feb. 12 despite mounting evidence that the coronavirus was already damaging the global economy. China’s economy, the world’s second largest, had been brought to a virtual standstill. Global supply lines had been disrupted, causing some factories elsewhere to close. International trade was falling. And the source of all this, the highly contagious Covid-19 virus, was already spreading to other countries.

Some of us had been warning for weeks about the threat of the coronavirus because it inflicted “cascading economic sudden stops,” which are common in fragile and failing states but not in systemically important economies. They are highly disruptive because they destroy both demand and supply at the same time. As such, this was an urgent and complex policy priority that did not provide a “buy-the-dip” opportunity for investors.

These warnings fell largely on deaf ears, and for understandable reasons. The sudden stop dynamics, while extremely consequential, were largely unfamiliar to the vast majority of economists and policy makers. Similarly for Wall Street analysts, investors and traders who — conditioned by years of ample and predictable liquidity provided by central banks and amplified by the “fear of missing out”— had developed an almost automatic response to buy any market pullback regardless of the cause. This combination had evolved into a seemingly can’t-miss approach as central banks’ ability to repress financial volatility and shield elevated asset prices from more sluggish corporate and economic fundamentals drove stocks from one record to another.

But as the coronavirus devastated more of the Asian economies, paralyzed northern Italy and was reported in several other European countries, the evidence became overwhelming that this was indeed different. Company after company reported blows to actual and future profits as revenues shrank, costs increased and even people and inventory management became much more difficult. With the United States also threatened, there was no denying that this was now a serious economic shock that would have financial consequences — the first two stages of the four-stage process I detailed a month ago.