Lockdowns, Slowdowns and the Adaptive, Efficient Market

October US retail sales missed expectations this week, rising just 0.3% m/m—a big slowdown from September’s 1.6% jump.^[i] While a slowdown from this summer’s torrid growth rates was always inevitable once society reaped that low-hanging fruit—and retail sales are a narrow slice of consumer spending and often volatile—pundits had a darker view. According to the popular interpretation, this wasn’t just consumers returning to more normal spending patterns after a severe interruption. It was a foretaste of worse things to come as more businesses shut down again this autumn and the lockdown Grinch steals Christmas. Stocks, they say, will then fall to earth as vaccine euphoria wears off and reality sets in. We don’t buy it. Markets are forward-looking, and we suspect that even some contractionary data wouldn’t shock markets. Exhibit A: Europe. Despite some negative economic readings, markets have overall continued rising. In our view, that shows you markets are looking far beyond the next several weeks—as they normally do in a young bull market.

On Monday, eurozone stocks finally closed at new highs, passing their pre-pandemic peak in US dollars.^[ii] This month alone, they are up a whopping 18.1% in dollars through Tuesday’s close.^[iii] (They are up 15.8% in euros, so that huge rally isn’t just a figment of currency translations.) Over these 17 days, much of the region has dealt with new COVID restrictions, many of which began in October. Those restrictions’ effects have now begun showing up in economic data. It started on November 4 with contractionary October services PMIs in the eurozone and its four biggest economies: France, Germany, Italy and Spain. The next day, September retail sales hit the wires. They fell -2.0% m/m, hobbled by the new restrictions taking effect in several major cities that month.^[iv] The following week brought September’s French industrial production (-5.6% m/m), eurozone industrial production (-0.4%) and a handful of deeply negative sentiment surveys.^[v] All of these reports received widespread attention. Stocks soared anyway.

In our view, this demonstrates a lot about how markets work. They efficiently discount widely known or anticipated factors. For months, many have anticipated an autumn COVID resurgence triggering lockdowns. Virtually everyone knows lockdowns interrupt business. Markets likely reflected this long before those factors became a reality, part of the steep decline back in February and March, as they reckoned with lockdowns’ deep economic impact before any data showed it. That is a textbook example of markets’ efficiency. Once stocks fathomed the recession’s likely depth and duration, they were able to begin pricing in the recovery. For markets to react now would likely take restrictions that meet or exceed the spring’s stringency, with fallout much deeper and more lasting than looks likely today.

If markets correctly registered early 2020 lockdowns’ impact by enduring the fastest, sharpest bear market in history, then is it really logical to say they are now responding to new restrictions and bad data incorrectly? We don’t think so. Markets don’t get dumber over time—we think they are adaptive, applying the lessons of the past. Therefore, it isn’t likely stocks are blissfully disregarding new lockdowns, bad data and future economic risk. A better thesis, in our view, is one that recognizes markets’ efficiency and forward-looking nature.

That thesis: Stocks are looking beyond the next three or even six months. Instead, they are looking out over the next year, two or more, to a time when more of society is immune to COVID, whether because the vaccines that are presently rounding third base are widely available, or because of the virus just naturally running its course—or maybe some combination of the two. That is certainly the expectation of market analysts, who are penciling in 20%-plus earnings growth next year on the back of a continued economic recovery. They made these expectations with full knowledge of new restrictions this winter, just as people have bought stocks eagerly over the past two weeks with that same knowledge. Seems to us people have realized that even if trouble resurges in the here and now, it doesn’t mean a ton for earnings over the medium to longer term. One way or another, society will likely continue adapting to the virus and learning how to live with it, enabling normal activity to resume. We think markets developed that viewpoint far before it began becoming more common with vaccine development news.

All the warnings about worsening data eventually taking a toll on stocks amount to saying the market is wrong. Hey, markets aren’t perfect. But they are much more efficient than headlines often presume. Starting from the basis that the market is wrong is the starting point for many grave investment errors. To achieve market-like returns over time, you have to be invested during bull markets. Briefly interrupted economic recoveries, and the sharply negative sentiment that accompanies them, create the temptation to bail. But if you bail and stocks rise through the bad news, the missed returns can be a setback to your long-term goals.

So whenever you hear warnings of trouble to come, ask yourself: Are the reasons cited well-known? Is the information backward-looking? Has it been discussed for months? Would that trouble, if it were to happen, surprise anyone? If the answers are yes, yes, yes and no, then in our view, getting out of stocks is highly likely to prove the wrong move. Instead of falling prey to the temptation, think like markets do, and look to the brighter future ahead.