Stock Bulls Need A Shock Stimulus To Revive The Rally

A common thing to say right now is that the stock market needs a fiscal stimulus package to resume its trend higher. The market dynamics since the Sep. 2 top simply do not align with this view.

Cyclical value stocks have outperformed growth companies, the Russell 2000 is beating the Nasdaq NDAQ , the 10-year yield is higher, and reopening trades are mostly unchanged. You’d expect something close to the opposite if the weakness in the market was about the economy rolling back over. In fact, technically speaking, it’s probably easier to argue that a deal is already being priced in. The dollar and bitcoin seem also to agree.

It’s an uncomfortable notion for many — that the stock market could be pricing in a multi-trillion-dollar stimulus and still be below all-time highs – but it makes a good deal of sense. Even more uncomfortable is embracing the notion that truly positive economic developments will likely be, in the short to intermediate-term, negative for the U.S. equity market.

The price of stocks boils down to two things: earnings, and the valuation assigned to those earnings.

Gains over the last two years have been almost entirely attributable to valuation expansion, according to Goldman analysts led by David Kostin. With the Fed on the sidelines, the most obvious catalyst for that expansion is on hold. Meanwhile, tech’s unparalleled growth during this crisis may also soon be losing some of its effect on the market. As the recovery gradually takes hold, the spread between growth offered by tech (accelerated by COVID) versus the economy (destroyed by COVID) will begin to narrow, reducing the risk-reward of paying up for growth at the highest rates since the invention of the internet.

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A large fiscal impulse to the economy through stimulus would be positive for S&P 500 earnings, but to be net-positive for the market overall, it has to be a big enough catalyst for sectors like banks, consumer cyclicals and industrial stocks to offset any valuation contraction in tech. How big might that be? Who knows, but the $1.8-$2.2 trillion doesn’t seem to be it. And even if it’s a shock size, what we’ve learned over the last few months is that a market geared toward recovery, one in which cyclicals outperform, is one that grinds sideways to lower.

The type of deal that seems the most stock-positive is one that includes a big cash drop, which aligns more with valuation expansion and big spending than a limited deal that plugs the holes in the economy.

The headline here may be somewhat sensational. At just four percent off the highs, the stock market doesn’t exactly need saving. But with markets drifting lower and rallies fading since the Nasdaq failed to reach a new high, investors are a bit lost at sea right now. There may not be sharks looming in the water, but it wouldn’t hurt to bring a big boat anyway.

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