Rosenberg: This is when the stock market rally is likely to unravel – and it’s not going to be pretty

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Hope and faith can be powerful at times.

Just look at the rotation we have seen in the economic reopening segments of the S&P 500: casinos (up 70 per cent), restaurants (45 per cent), airlines (40 per cent) and banks gaining 24 per cent, all from their recent lows, as of Wednesday’s close.

We all know the world economy is reopening, but we also know that until we get a vaccine the re-opening will be slow and sluggish because the economy is going to be constrained both on the demand and supply sides.

So what the market is telling us now, in this rotation away from the megacap “stay at home” growth stocks toward reopening/recovery value stocks, is that a vaccine is close, that we are then going to be in for a huge V-shaped recovery. Make no mistake, this is what is priced in right here and right now and, in terms of timing, I sense Mr. Market is thinking by the fall, everything is going to return to normal.

That’s not my view, and while I am not an infectious-disease expert, I do know a thing or two about assessing probabilities. On one side, we do have the best people working on this file 24/7. And I do sense that we are much further ahead on these early clinical trials than anyone would have thought a few months ago, when the COVID-19 virus was being compared with the Black Death or Spanish flu. It’s clearly neither of those.

But a vaccine has never been developed, ever, in the time frame the stock market has priced in. It takes, on average, four years to get a vaccine. From the people I talk to, we are not looking at anything being successfully tested and developed before early spring or summer of 2021. That would mean, at best, a very weak recovery with mountains of unemployment and bankruptcy, and that assumes we don’t go back into lockdown mode.

If we go through the summer, and by Labour Day we don’t have a vaccine developed and ready for production and distribution for 2021, this rally is going to be in some serious trouble. The Fed may try to defend the market lows with policy stimulus, but it won’t be able to prevent a retest of those lows if we don’t get a vaccine in that period. That is all that matters for the stock market, full stop.

We know what the market has priced in and what it is willing to ignore. If there is no vaccine success by the end of the summer, risk assets will have a very tough time with that, and what I now call the “benefit of the doubt” rally will peter out and roll over.

We have to tack on the added complication of a U.S. election in November. Donald Trump is trailing badly in the polls, even in some of the key battleground states, and I see in the betting markets that the Senate is now a toss-up. The market is not looking that far out, but I can tell you that a Democratic sweep would not be good news for capitalism or the stock market, and while top marginal personal, corporate and capital-gains tax rates won’t go up immediately, they will be going up at some point. All the portfolio managers who are bullish today because they don’t see the current situation as impairing the long-run normalized earnings curve will undoubtedly have to start making some permanent downward adjustments to that curve on an after-tax basis.

So, my advice here, given how much risk there is this fall, is to start thinking about looking for opportunities in the options market with an expiry in the September-October period.

There is a lot of excitement in the marketplace around the reopenings. But while the economic numbers, the high frequency weekly and daily trackings are showing less negative readings, the U.S. economy is still struggling.

It isn’t just about reopening, because physical distancing is going to impair capacity in practically every industry, including the consumer cyclical service sectors that have been rallying sharply lately. What is going to matter most is demand. There is no renewed hiring cycle that brings the unemployment rate back down without it. And without that vaccine, consumer confidence is not going to revive enough to generate the demand that will absorb the gargantuan amount of excess capacity that has been created during this crisis, leaving a trail of bankruptcies and a double-digit unemployment rate in its wake.

This isn’t in the market pricing today, but I see this is as a big risk once the summer shifts to the fall.

David Rosenberg is founder of Rosenberg Research and author of the daily economic report Breakfast with Dave.

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