If you’re scratching your head over the market’s strong rebound since March, then join the club. Because there’s still a large cohort of economists and analysts who continue to see tough times ahead.

I recently pointed to a definite recovery off the low levels of activity recorded  during the COVID-19 lockdowns.  Optimism in the US about the relaxation of lockdown restrictions at both a state and business level, as well as hope for a coronavirus vaccine, has now seen the S&P 500 index rise 36 per cent from its March lows. Despite the unlikely event of a full recovery to pre-crisis levels of activity any time soon, the S&P500 has now cut its losses for the calendar year to just six per cent at the time of writing.

In Australia, a camp full of seasoned investors sees dark clouds on the horizon and conclude a V-shaped recovery is doubtful, pointing to lasting impacts from the COVID-19 crisis, including higher unemployment, small business contraction, lower population growth and weaker confidence.

But the market appears almost single-mindedly optimistic and a bull market is often characterised by its ability to climb a wall of worry.

The idea of limitless fiscal and monetary policy stimulus, must be considered because unless there is a meaningful second wave of infections, the ‘re-opening’ data both here in Australia, and importantly, in the US, is emerging better than expected.

In mid-May, former treasurer Peter Costello observed, when referring to the stock market’s optimism, “Markets have decided the crisis is over…I’ve got to say, it’s a pretty optimistic view that it’s all over now…I don’t know that it really makes a big enough allowance for… that even when we do come back, we’re not going to come back to 100 per cent of where we were.”

And more and more economists, both here and in the US, concur with Costello’s view, noting growing signs the breakdown in economic activity has bottomed and a recovery is underway.

Importantly, there is a difference between Costello’s definition of a ‘recovery’ and the one held by both the market and economists. If a recovery is something like a boxer standing up off the matt after being KO’d, then we are, economically, well and truly in a recovery.  If, on the other hand, the definition of a recovery is a return to full strength and prior levels of economic activity, revenues and profits, then we are a long way from it.  Both are simultaneously true; we are in a recovery and yet we aren’t going to recover.

I recently noted the very high price to earnings ratios of both the ASX 300 and the US S&P500.  It caused some to write that we are in another bubble, and while in aggregate the combination of falling earnings per share and rising prices are unsustainable, there are many businesses whose share price gains reflect high earnings power and healthy unleveraged balance sheets. It is towards these companies that most of the capital is flowing.  Indeed, to that point, it is worth noting the Barron’s recently reported that the Nasdaq’s ten largest stocks, which includes Facebook, Amazon, Apple, Netflix, Google, Intel, Nvidia, and Cisco have increased their market capitalisation by almost US$1 Trillion.  This is triple the total gain of the remaining 2990 companies.

Concentration risk may yet be a bigger issue than any other black swan.  Share prices have been rotating – admittedly mostly upwards – around four factors; Government health initiatives and responses, the economic impact of those initiatives and responses, the fiscal and monetary policies to combat those economic impacts and the prospects for a vaccine or treatment. However, the key driver of higher markets amid potentially poor economic prospects is what we call The Fed Put – central bank buying of assets to support prices while simultaneously destroying natural price discovery.

We know this year with certainty that the Trump administration is going to run a fiscally-irresponsible deficit surpassing any previously established record. The US Federal Reserve will be forced to buy bonds protecting the world from a flooded bond market, rising yields and cratering asset prices.

In measuring the level of bullishness and bearishness in the market, Barron’s recently revealed just 39 per cent of US fund managers were bullish on the equity market for 2020, while 20 per cent were bearish and the reminder – the 41 per cent – were ‘neutral.’ This is despite the fact that the S&P 500’s first quarter earnings are expected to fall by almost ten per cent, before falling even more in the second quarter. But Barron’s also revealed that nearly 85 per cent of fund managers are bullish on the prospect for equity markets for calendar 2021.

Perhaps the only danger is the possibility of a second wave of infections that force another round of lockdowns. In the US state of Georgia, which was one of the first states to begin re-opening nonessential businesses at the end of April, the seven-day moving average of coronavirus cases steadily declined from late April until mid-May, reflecting the effectiveness of earlier lockdown measures. According to CNN, the moving average of active cases flattened.  And according to JP Morgan research (never ask a barber whether you need a haircut), almost all US states have seen lower infection reproduction rates (R rates), even after adjusting for a lag in new infections, after lockdown measures were lifted. JP Morgan concludes that an echo wave of the scale experienced during the initial outbreak should not be relied upon by bargain hunters.

As the health risks abate (notwithstanding the possibility of a second wave), the de-risking that occurred ahead of the virus’s spread will reverse and eventually be completely unwound.

What will remain are idiosyncratic opportunities. Investors need to be cognisant of the fact that there will be many companies that emerge stronger than they entered the crisis. Those whose equity was not diluted by deeply discounted capital raisings, those that will return to an environment with weakened or reduced levels of competition, and those that will enjoy a surge in sales from pent-up demand and the aforementioned support from fiscal and monetary policy, will be favoured by investors still looking over their shoulders for black swans or fat-tail risks.