Point/Counterpoint: U.S. Stock Bulls Vs. Bears

By Yasin Ebrahim and Kim Khan

Investing.com - Wall Street ended the week with another strong gain as investors managed to shrug off the worst drop in nonfarm payrolls ever.

The Nasdaq Composite turned positive for the year this week, with tech stocks remaining a particular point of strength. And sentiment looks strong as earnings season winds down and states across the U.S. begin to reopen their economies.

But has the rally got legs as summer approaches?

Yasin Ebrahim contends that the Federal Reserve will do whatever it takes to support the economy and for the foreseeable future equities remain the only game in town.

Kim Khan argues that the rally looks narrow, the employment picture will worsen and the days of tax cuts are in the rearview mirror. This is Point/Counterpoint.

The Bull Case

The Covid-19 pandemic has destroyed the jobs markets and left many businesses on the brink of financial ruin. But the pandemic's grip on equity markets has seemingly been short-lived as swashbuckling gains have followed on Wall Street since the March 23 lows.

Pointing to the disconnect between underlying economic conditions and surging equity markets, many are scrambling for answers at a time when the ultimate economic cure – a Covid-19 vaccine - is still some ways off.

But for others the explanation is simple: the Federal Reserve.

The most powerful central bank in all the land has cut rates within a quarter percentage point of zero and pledged to do whatever it takes to ensure that an eventual economic recovery is robust.

The Fed has expanded its asset purchases beyond Treasuries to include investment-grade debt, municipal bonds, ETFs and junk bonds, helping to stabilize credit markets and lay a softer landing for the coronavirus-ravaged economy.

The spending so far has taken the Fed's balance sheet to nearly $7 trillion, with the central bank recently conceding that it would need to more to support the economy.

The unprecedent move into unconventional markets and unrelenting support from the Fed has strengthened the narrative that the Fed will do whatever takes to support the economy.

"Don't fight the Fed," Morgan Stanley (NYSE:MS) said in a recent note. "This move (the Fed's $2.3 trillion stimulus) is in-line with our prior view that investors should have no doubt about the Fed’s resolve to do whatever it takes to make sure the recession does not turn into a depression."

Beyond the Fed, Congress has also ensured the well of stimulus remains deep, rolling out about $2.4 trillion in coronavirus aid to support individuals and businesses impacted from the coronavirus crisis.

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Equities -- The Only Game in Town

With U.S. rates currently languishing at near zero and expected to turn negative next year, sitting in cash is not attractive, so equities remain the only game in town.

"(T)here would be no other place for these cash balances to go than chasing equities and bonds in the world as the need for precautionary savings subsides over time," JPMorgan (NYSE:JPM) said.

But the flows into equities are not indiscriminate. Unsurprisingly, it is the FAANGs -- Facebook (NASDAQ:FB), Apple (NASDAQ:AAPL), Amazon (NASDAQ:AMZN), Netflix (NASDAQ:NFLX), Google-Parent Alphabet (NASDAQ:GOOGL) -- and others like Microsoft (NASDAQ:MSFT), Zoom (NASDAQ:ZM) and Slack (NYSE:WORK) that are best suited to the current pandemic and beyond that are attracting attention.

While stimulus has played the biggest role in the most recent rally, the gradual lifting of restrictions across the country has underpinned hopes the economy has weathered the worst of the pandemic.

"We expect GDP to grow ... as firms and households learn to combine higher economic activity with continued virus control via a range of adjustment mechanisms including mask and glove wearing, frequent cleanings of workplaces, lower office and retail occupancy, and improved testing and contact tracing," Goldman Sachs (NYSE:GS) said.

Without a coronavirus vaccine the possibility of a second wave of infections could threaten the current rally, but for the time being traders are willing to bet the Federal Reserve “put” will remain in place until a Covid-19 vaccine is found.

The Bear Case

Investors should beware the bubble. Not an asset-price bubble bears usually speak about, but an economic bubble.

This rally has happened in a bubble where the economy had to be shut down, but the Federal Reserve and the federal government provided an unprecedented backstop. As state governments attempt to reopen and the limitations of that backstop are evident, a lot of valuations will be called into question.

Investors will always be reluctant to fight the Fed, especially one providing historically large liquidity and with a fed funds rate tilting to negative for the first time. But the unprecedented action isn’t creating unprecedented enthusiasm.

“While hedge funds have responded to lower prices by their equity exposure from the lows of late last year, they have gone back only to a neutral allocation,” Andrea Cicione, Head of Strategy, at TS Lombard said in a note this week. “And both institutional and individual investors remain somewhat bearish.”

Breadth shows wavering conviction as well. The percentage of stocks trading above their 200-day moving average is 20%, compared with 70% to 80% last year when the S&P (NYSE:SPY) was around the same level, Cicione noted.

The current high equity prices also seem to be dismissing the seismic shift that’s happened to the economy, pricing in a V-shaped recovery where the angle of the V is approaching 0 degrees and things are reverting back to how they were in no time.

Friday’s employment report brought into sharp relief the pandemic economy landscape. The BLS reported that 20.5 million jobs were lost last month and the jobless rate spiked to 14.7%.

Jobless claims figures gave investors a good idea of what to expect, but stocks have still rallied. A lot of that may have to do with expectations of a sharp rebound by both investors and those recently out of work.

About 77% of laid-off or furloughed workers expect to be rehired by their previous employer, according to a Washington Post/Ipsos poll out this week. But economists aren’t so optimistic. The Post also noted that a report from the University of Chicago’s Becker Friedman Institute predicted that 42% of job losses from the pandemic will be permanent, with businesses closing and spending curtailed sharply even after reopening.

Meanwhile things could still deteriorate. The Minneapolis Fed’s Neel Kashkari said Thursday the true unemployment rate could be as high as 24% and the recovery will be “slow”.

The new landscape will likely also feature something to which Wall Street is especially averse: higher taxes.

The Treasury is borrowing a record $3 trillion this month to pay for the stimulus programs launched to stabilize the economy. And there could be more programs to come if Republicans and Democrats can agree.

“There is one clear implication: The era of tax cuts is over,” Jim Millstein, co-Chairman of Guggenheim Securities told Bloomberg. “People who have been fortunate enough to be able to make significant incomes are going to have to make a greater contribution.”