Is There a Perfect Storm Brewing in the Stock Market?

The coronavirus pandemic has made this a wild and wonderful year for Wall Street and investors. The panic caused by the virus at first sent the broad-based S&P 500 lower by a staggering 34 percent in a matter of a little over a month. It took a scant 17 days for the index to drop from an all-time high straight into bear territory.

However, that is now old news. Since then, the market has roared back with the most ferocious rally the S&P 500 has ever witnessed. In less than five weeks, the market erased the losses attributable to the coronavirus. Despite recent losses, the index is still higher when compared to this time last year.

When the market is going through a correction phase, it has historically been a time to buy. Historically, every stock market correction has eventually been erased by a bull market rally. Investors who bide their time, exercise patience, and are diligent about selecting new opportunities have witnessed equity value expansion over time.

Wall Street May Be in for a Disappointment

In the last few months, the market has witnessed the most violent bear-market crash in stock market history. The market has subsequently rallied and snapped back. Might Wall Street be setting itself up for a huge disappointment?

Many investors and market pundits are pointing to valuation as a reason for concern. Using the Shiller price-to-earnings ratio, which is based on 10-year moving inflation-adjusted earnings, the number sits at 33. It has only been above 30 on three different occasions: just before the Great Depression, just before the dot-com bubble burst, just before the Q4 equity swoon of 2018. Using the only three examples, a P/E ratio above 30 is a harbinger of bad news.

However, game-changing businesses such as Amazon and Netflix pay scant attention to traditional metrics and keep heading upward.

What Might a Perfect Storm Look Like?

Granted, valuation alone is insufficient justification for a market crash. However, by no stretch of the imagination does the stock market get a free pass. At the moment, a perfect storm may be brewing, one that might ravage equities over time. This, even though the Fed is pumping up the market.

During the last 10 years, repurchases of common stock have driven the demand for equities. The cumulative buybacks for S&P 500 listed companies from the first quarter of 2009 through the first quarter of 2020 totals $5.63 trillion. From all appearances, 2020 is going to result in a low level of stock buybacks. The Fed recently released the results of its annual stress-testing of banks. Perhaps the biggest surprise was the Fed’s decision to restrict capital distribution. The stress-testing exercise, which included 33 banks, each one having in excess of $100 billion in assets, suggests that bank’s capital levels may be significantly impacted should the coronavirus persist. As such, the Fed capped dividends, not to exceed those paid in Q2.

A dramatic drop in the crude oil price has forced some players in the oil and gas industry to either cut or halt paying dividends. The same holds for the airline industry. Virtually every airline has suspended paying dividends and their share repurchase programs.

The Impact of a Lapse in Stimulus Money

Despite the stock market showing some evidence of strength within specific industries, including cybersecurity, cloud computing, and telemedicine, the heart of the United States economy is consumption. Approximately 70 percent of the American economy relies on consumption, something that is being threatened by the stalled stimulus negotiations on Capitol Hill.

The U.S. has taken action, which has helped stave off evictions, foreclosures, credit delinquencies, and more. With the lack of stimulus money, many hundreds of thousands of people in the U.S. will be looking at a financial situation that can and may negatively impact consumption, the driver of the American economy.