The Sentiment Overshoot That Spurred Stocks in 2020

As we reflect on 2020 in its waning hours, it is easy to think of many ways this year will be remembered as one of history’s worst: the pandemic’s vast public health impact and the related tragedies many families endured; the sudden, sharp hit to employment and small businesses; the dislocations from social distancing and school closures. As much as this is the undeniable reality of the year, though, there is another thing to consider: How much better than feared the economic reality has been since the lockdown-induced contraction in the spring. While we don’t diminish the year’s general awfulness, we think it is worth acknowledging that this better-than-feared reality likely contributed mightily to the swift bull market that began in March.

In the early, hugely uncertain days after Western nations began locking down in an effort to slow COVID’s spread, pundits pretty much everywhere agreed the hit would be severe. Comparisons to the Great Depression were front-page news in many major outlets worldwide. Yet expectations from the crisis’s pessimistic depths for everything from annual GDP growth to earnings and unemployment have proven overly negative.

Consider GDP. In the lockdowns’ immediate wake, everyone was sure the damage would be severe—and it was. In Q1 and Q2 2020, US GDP fell -5.0% and -33.1% annualized, respectively.^[i] Now, that doesn’t mean output actually fell that much in each quarter. As we took pains to explain at the time, annualized rates are the full-year rate that would result from the quarter-over-quarter growth rate repeating all four quarters. Using the actual quarter-over-quarter rates, GDP fell by -10.1% from Q4 2019’s high through Q2 2020. That is the worst two-quarter contraction in terms of magnitude since quarterly data begin in 1947. But it isn’t on the Depression’s level. Across that three-plus-year downturn, economists estimate GDP fell by roughly a third—nearly three times 2020’s decline, including one year (1932) in which GDP fell -12.9%.^[ii]

Severe as this year’s downturn was, it came and went superfast, undercutting many forecasters’ dire outlooks. In June’s economic projections, the Fed forecast a -6.5% year-over-year contraction in Q4 2020.^[iii] By September’s update, it had cut this to -3.7%. They cut it again in December, to -2.4%. Consensus Wall Street forecasts show a similar evolution. In July, the median of 88 broker forecasts for 2020 US GDP called for a -5.5% decline.^[iv] Now? -3.6%. Q3 2020’s 33.4% annualized rebound—plus a continuation most forecasters anticipate in Q4—seems set to make this year’s drop smaller than nearly everyone feared.

Unemployment tells the same tale. When April’s headline unemployment shot up to 14.7% from March’s 4.4%, headlines far and wide invoked Depression comparisons, with visions of 25% unemployment and crowded bread lines frequenting news analysis.^[v] Many presumed it a foregone conclusion, considering the broader U6 rate that includes workers who haven’t sought jobs in the preceding four weeks was already above 20%. But then reopenings started. May’s Employment Situation Report showed a shock gain. June’s followed it up. By July’s Fed forecast, it seems central bankers noticed the improvement and expected the headline unemployment rate to finish 2020 at 9.3%.

Like GDP, even this proved too pessimistic. In September, they cut their estimate of year-end unemployment to 7.6%. This month they cut it again, to 6.7% (which happens to match November’s reading).^[vi] Mind you, this is still well above December 2019 levels. But it is nowhere near Depression levels. The U6 rate is down to 12.0%, a 10.8 percentage point drop from April’s record high.^[vii]

On earnings, Q3’s final figures show the same thing. Halfway through the year, analysts expected earnings to fall by -25.3% y/y in Q3 2020.^[viii] By earnings season’s close in early December, the actual figure was -5.7%.^[ix] In mid-December, analysts projected Q4 earnings to fall -9.7% y/y. They have already been ratcheting up S&P 500 earnings estimates since Q4 began. But still, would it be any surprise if this forecasted drop proved overstated?

One other major fear early on was that the pandemic’s impact on state and local tax revenue would cause a crushing wave of defaults or cutbacks. As Bloomberg recently reported, “Last spring, Capital Economics predicted the economic devastation wrought by the coronavirus would mean a plunge in the tax receipts of state and local governments, causing budget shortfalls of $300 billion to $400 billion over two years. But deficits in the year ended June 30 were only about $30 billion above pre-pandemic projections, and deficits in the current year are likely to be in the same range ….”^[x] This doesn’t mean some state and local officials face no hardship—just that the scale is far less than most presumed.

There is no doubt that, all the way around, 2020 has been a bad year. But for many economic and market data points, it didn’t prove as bad as expected. Ultimately, because stocks move most on the gap between reality and expectations, that is about all they needed to move on from the shock lockdowns’ impact in February and March.