Stimulus Impasse May Bring An End To The Stock Market Rally, For Now

A sudden spike of volatility last week cause fear among investors, who are now wondering if the rally is over. Who can blame them? Even after the 7% drop of last week, the S&P 500 is well in the black for the year even as the economy had the worst contraction in generations, not to mention a pandemic that is still bringing 40,000 new cases of Covid-19 a day. There are plenty of reasons for investors to believe that the rally has gone as far as it can go.

The recent drop, however, is well in line with the declines of April (-6%) and June (-7%). The S&P has not even broken a 5-month trendline, against which it bounced a few times. At least from this perspective, the rally appears to be fragile but intact.

Last week’s decline was largely attributed to options trading in some of the skyrocketing technology stocks, which have been the big winners this year. The options scheme is quite technical and appears, atypically, led by small investors rather than institutions. It involved large purchases of deep-in-the-money options that forced options sellers to purchase large amounts of the underlying stocks to hedge their sales. At any rate, the run-up in prices caused by those options strategies came to an end last week and those high-flying stocks plunged.

There might be another explanation as well. On Thursday, September 3, the Labor Department revealed 881,000 new unemployment claims for the week of August 29 – far lower than the 960,000 claims the market expected. Existing unemployment claims fell more than 1.2 million to 13.2 million, the lowest level of the crisis.

While this is good news for the economy, a larger-than-expected improvement gets in the way of further fiscal and monetary help. Although many economists and analysts argue that the economy is in dire need of more stimulus, some conservative lawmakers question the need of piling up debt when the economy seems to be healing on its own. Accordingly, the S&P 500 fell 3.5% on Thursday despite – or because – the better-than-expected employment numbers.

In explaining their reluctance to approve more stimulus, some GOP senators argue that all the help approved earlier in the crisis has yet to be fully spent. Among the programs they want to cut are the Federal Reserve’s large emergency lending facilities which, they argue, are underutilized and unnecessary. They also seem to be in no mood to extend any help to state and local governments, which Democrats demand. As a result of this impasse, a new stimulus bill failed in the Senate today, Thursday September 10. And, like last week, the S&P 500 fell, losing 1.8%.

While options trading may have had something to do with last week’s decline, it seems clear that the market does not like the mounting doubts surrounding the passage of more government spending. Stocks recovered from a major loss in large part because of the huge amounts of money deployed to prevent the economy from sinking. If the spigot is shut off, the market is likely to suffer.

While rock-bottom interest rates and better-than-expected earnings can soften the impact of reduced liquidity in the absence of a new stimulus bill, it may be difficult for the market to rally a lot more this year. Among the few things that can push prices up if stimulus does not come would be a Covid-19 vaccine, or a presidential election that goes without a hitch – even if having to hope for the latter is in itself dispiriting.

A big danger for investors right now is to react to what is likely to be a range-bound, volatile period by aggressively paring down their holdings. Not only it is exceedingly difficult to time exit and entry points successfully, but the likelihood that the economy will improve in the months ahead is high. There are ways of controlling portfolio volatility without having to exit the market. Investors should keep calm and think carefully about their next move.

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