Markets are up and the economy is down. Some next moves for investors

The New York Stock Exchange.

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The financial markets are rising and the economy is falling. What is with this disconnect between the two? Many investors may be asking themselves if this is all a cause for concern.

So, what’s an investor to do?

To begin with, the financial markets were doing quite well before the pandemic. In fact, the S&P 500 Index closed at a record high (3,386) on Feb. 19. But once Covid-19 cases started spreading in the U.S., the markets plunged. By March 23, the S&P 500 had fallen about 34%.

Fast forward a few months, however, and the numbers tell a different story. By the end of the first week in August, the S&P 500 had risen nearly 50% since March 23, regaining almost all the ground it had lost.

Meanwhile, at the same time of this market rally, the overall economy took a hit.

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In fact, gross domestic product fell 9.5% in the second quarter of the year – the largest quarterly drop since 1947. If businesses are producing and selling fewer goods and services, shouldn’t it follow that the accompanying damage, in the form of massive lost revenue, would also lead to a sharp decline in the stock prices of these businesses?

There’s something of a time warp between what’s happening in the economy and the performance of the financial markets. Essentially, the economy is a reflection of what’s happening today, but the markets are always looking toward tomorrow.

This pattern can be seen in recent market action. The 34% sell-off in February and March took place when unemployment was near 50-year lows, as the market declines reflected concerns over the growing pandemic and the anticipation of the resulting recession. But now, stocks have rallied in expectancy of a better economic environment in the second half of 2020 and into 2021 as economic activity recovers.

Here are a few reasons for the market’s optimism:

Gradual improvement in corporate profitability: Corporate profitability – always a key long-term driver of stock prices – will likely show gradual improvement, based on a sustained, but probably uneven, economic recovery, which may result from government stimulus efforts and a rebound in consumer activity, boosted by pent-up demand.

The various lockdown efforts have resulted in consumers having fewer places to spend their money and, in combination with considerable government aid, have led to an extraordinarily high personal savings rate. And corporate earnings should further be bolstered by low interest rates and businesses’ cost-cutting efforts.

Vaccine progress: The worldwide drive toward finding a vaccine to treat the coronavirus is truly unprecedented. Several companies, working in concert with the government or academic institutions, are reporting encouraging results in early stage trials, and top infectious disease experts now say an effective vaccine may be ready in early 2021. Such a development would boost consumer confidence and allow economic activity to return to pre-pandemic levels.

Federal Reserve actions: The Fed has made clear it will do everything in its power to support an economic recovery. Chief among its actions are moves to keep interest rates near zero for an extended time period and to continue buying bonds.

Keeping interest rates and credit costs low for the foreseeable future will help reduce some of the market’s “downside” risk that would have been more pronounced without the Fed’s backstop.

Despite the possible causes for confidence described above, there are still no assurances that the financial markets will continue their upward trend. The biggest reason for uncertainty, of course, is Covid-19 itself. If more spikes lead to complete or even partial lockdowns, and schools go through chaotic re-openings, the resulting economic slowdown could cause investors to take a pause, leading to downward pressure on the markets.

In fact, there’s fairly widespread agreement that, until we get control of the virus, either with a vaccine or through rigorous observance of social distancing, mask-wearing and other measures, the economy will not really be on firm ground.  It shouldn’t be surprising if economic and earnings data display a mixture of encouraging signs and periodic setbacks, possibly leading to market volatility.

The financial markets, following an initial coronavirus-induced decline, have rallied strongly for several months, envisioning an improving economy, a government stimulus package and the ultimate arrival of a vaccine. Yet, great uncertainty remains over our near-term ability to contain the virus and the potential economic fallout from new lock-downs and school openings.

So, what should investors do?

Consider these suggestions:

Maintain realistic expectations. We’ve seen some impressive gains in the market recently, but this almost continuous march upward was never going to last indefinitely. It’s far more likely that we’ll see considerable market volatility over the next several months, so be prepared.

Rebalance when necessary. You may want to think about re-balancing your investment portfolio. For example, during the recent market run-up, your holdings might have become over-weighted in some categories, such as technology. The largest five stocks, by market capitalization, in the S&P 500 (Microsoft, Apple, Amazon, Facebook and Google) have driven much of the gains in the index, and, in fact, now account for almost one-quarter of its value.

Your individual circumstances – goals, risk tolerance and time horizon – should dictate your investment choices, but, as a general rule, you don’t want to be too heavily committed to any particular stock, sector or asset class.

Diversify – and look for quality. For the equities portion of your portfolio, look for domestic and international companies with diverse, reliable business mixes and strong financial positions. These investments can help put your portfolio in better position to withstand increased market volatility in the short term, while giving you more opportunities to benefit from a longer-term recovery.

Spencer Platt | Getty Images News | Getty Images

These are challenging times. The key is to have some patience. As an investor with long-term goals, you might have experienced the initial market plunge, and then the subsequent rally, with various sentiments: shock, disbelief, elation and doubt.

However, if you maintain a long-term perspective and have the patience and discipline to weather short-term disruptions, as painful as they may be, you can go a long way toward taking the emotions out of your investment decisions.

Ultimately, what we’re going through now with the pandemic puts the economy and the investment environment in uncharted waters. And we may be in for a long climb back before things return to normal.

But keep in mind that the U.S. economic engine remains powerful, flexible – and resilient. If you follow a strategy that’s appropriate for your needs and risk tolerance, and you adjust your portfolio as necessary, you can keep making progress toward all your important goals.   

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