In this coronavirus stock market rally, the odds are stacking up either for another bull run or a stock market crash. The U.S. stock market rally has posted several record highs this year, and the warning signs are now flashing. So, let’s see if the bubble will burst for U.S. stocks or if the major stock indices like the Dow Jones Industrial Average, the S&P 500 index, and the Nasdaq
What is the Stock Market?
When we use the term stock market, it usually refers to the S&P 500 index. The S&P 500 index doesn’t represent the whole of the U.S. stock market; it represents the largest 500 American stocks. So, when one hears the word “stock market” in the media, it is loosely referencing the S&P 500 index’s performance.
Why the S&P 500 Isn’t a True Reflection of the Stock Market?
It is imperative to keep in mind that the S&P 500 index’s performance this year isn’t a true reflection of the U.S. economy. That’s because, since the coronavirus stock market crash, which formed a trough in March this year, the tech sector has been leading the gains for the S&P 500 index. Only recently we have started to see some sector rotation.
Sectors like materials, industrials and energy have seen some life breathed back into them this week. The financial sector still needs more prayers, while the hospitality industry is desperately waiting for a coronavirus vaccine.
Are Stocks Going Up or Down?
When it comes to the U.S. stock market, we have three major stock indices: the S&P 500, the Dow Jones Industrial Average, and the Nasdaq Composite index. So far, the S&P 500 index is up 10.84% year-to-date (YTD), the Dow Jones is up 2% YTD, and the Nasdaq is up 39% YTD.
One can see that the Nasdaq index has been the leading index, while the Dow Jones has been the biggest drag for the coronavirus stock market rally. Given the Nasdaq index’s performance, it is natural to think that there could be a bubble forming and that the Nasdaq might crash.
Let’s explore this a bit more.
Bubble: Nasdaq and S&P 500 are Extremely Overbought
Both the Nasdaq and S&P 500 indices are trading well away from their 50-day price average—a general price level that is closely watched among technical analysts. The S&P 500 index’s price is nearly 10% away from its 50-day simple moving average (SMA), while the Nasdaq’s price is trading nearly 11% above its 50-day SMA.
Historically speaking, the S&P 500 index usually sees its bubble burst when the price is away from its mean. We witnessed this most recently in June. The chart below shows the red rectangle displaying the stock crash for the S&P 500 and the Nasdaq.
A similar event is now imminent, and this can happen if tech stocks continue to sell off. On Thursday, before the stock market opened, we saw most of the tech stocks selling off. This could be just because traders want to take some profit off the table. However, if we see some upward momentum slowing from tech stocks, they will pull the S&P 500 index lower as well.
The Bull Case
The stock market bubble can continue to soar for some time for a number of reasons. Firstly, as mentioned in an earlier article, the U.S. stock market is very much in a Goldilocks scenario, meaning good news is good news, and bad news is good news. That’s because there is no doubt that the U.S. economy is experiencing a gradual recovery.
As long as the gradual recovery remains intact, the Fed will maintain its support for the stock market. The Fed’s support has saved the U.S. stock market from a further crash. However, if the gradual recovery changes into a strong recovery, investor optimism will rise, and the U.S. stock market will surge even more.
The second bull scenario for the stock market is a potential vaccine for coronavirus. Recently, the Centers for Disease Control and Prevention (CDC) told U.S. states to prepare themselves by November 1 for a potential coronavirus vaccine. This indicates that a Covid-19 vaccine may be here in under two months. This supports the bull case for another stock market rally.
Finally, conversations are still taking place around another stimulus aid package. Steven Mnuchin, the U.S. Treasury Secretary, mentioned this week that the U.S. economy needs another stimulus package for a full recovery to take place. Once we have more clarity on this, and we get the green light for another stimulus package, the stock market will take that as another positive sign. This could continue to balloon the stock market bubble.
The Bear Case
The reasoning for a stock market crash is basically the failure of all the bull cases discussed above. Firstly, if we do not get another stimulus aid package in time, the economic recovery will remain fragile. Investors are unlikely to continue to push the markets higher.
Secondly, there is a fair amount of hype around a potential vaccine, and any disappointment on this front is likely to make the coronavirus stock market rally more uneven, which could trigger a stock market crash.
Finally, supposing the Fed begins to tighten its monetary policy, an unlikely scenario under the current circumstances, markets may tank on the back of that.
Key Upcoming Catalysts
- As early as September – AstraZeneca vaccine Phase 3 results are due.
- In November – Moderna, Pfizer
PFEvaccine Phase 3 results expected.
- U.S. Stimulus Negotiations – Date TBA
The Bottom Line
There is no denying that the current stock market rally has gone too far and too fast, and there is a potential for a correction. But a full-blown stock market crash, for now, doesn’t seem to be imminent.