Markets don’t always do the very thing you expect them to do. With banking sector stresses sending shockwaves through markets around the world, it’s pretty extraordinary to see stocks holding up as well as they are. Here’s why stocks are doing so well, and what could happen next...

Why haven’t stocks tumbled?

That, my friend, is the question of the hour. When stress is rising sharply in the financial system (say, because some banks have failed and because it seems that high interest rates are finally testing its strength ), you’d expect investors to get really worried about what’s next for the global economy. That should be good for Treasury bonds and gold (they’re perceived as safe havens), and bad for risky assets like stocks, other commodities, and emerging market currencies.

So analysts the world over are wondering why it hasn’t been. In fact, Goldman Sachs recently put out a piece that compared what has actually happened in markets (first column) to what should have happened based on historical relationships and the rationale I explained above. It found that the fall in bond yields, commodity prices, and emerging markets was consistent with investors coming to expect a recession (third column), while the price action for stocks was consistent with investors expecting only a moderate growth impact (second column). Put more simply: stock investors seem unfazed about those banking troubles, compared to investors in other asset classes.

What you’d expect to happen (second and third columns) versus what did happen (first column). Source: Goldman Sachs.

OK, then why are stock investors unfazed?

First possible explanation: maybe bonds and commodity investors are wrong, and the economy is actually a lot more robust than it appears.

If you want to know what stock investors think about future economic growth, you can look at the relative performance between the cyclical and defensive sectors. As you’d expect, cyclical stocks outperform defensive stocks (blue line rising) when leading indicators like the ISM manufacturing purchasing managers index (PMI) are pointing to improving growth (yellow line), and underperform when they’re pointing to deteriorating growth.

But not since last year. That relationship interestingly has broken down and that suggests that stock investors aren’t buying the warning signs that leading indicators are flashing. In fact, cyclical stocks have been doing so well compared to defensive ones that it looks a whole lot like investors expect a strong recovery. Of course, it could also mean that another non-growth factor – like positioning – could be spoiling the relationship, and could at least partly explain the current divergence. But the fact is: stock investors are a lot more optimistic about the economy than other investors.

The outperformance of cyclical stocks (versus defensive ones) shows that stock investors are optimistic about the economy. Source: Morgan Stanley.

Here are the potential implications. If stock investors are right and the economy is indeed more robust than what bond and commodity investors believe, then stocks will probably do well. But don’t expect to see a slam-dunk: positive growth is already somewhat priced in (particularly for cyclical stocks), and a more robust economy may keep inflation hot and force the Fed to hike interest rates even higher, or keep them higher for longer, which could limit your gains. In that case, a potentially more attractive investment idea could be to bet on commodities, shorter-dated government bonds, and emerging markets currencies, as they’d have some catchup to do.

Second possible explanation: stock investors expect the Fed to cut interest rates to offset growth and credit shocks.

Stock and bond investors may agree on one thing: as the risks of a financial accident rise the Fed becomes more likely to pause its rate hikes, and may even cut rates, should the situation warrant it. As long as the threat doesn’t materialize, and as long as growth risks remain mild, then monetary easing (i.e. rate cuts and other stimulative measures) could alleviate the pressures on stocks, and support their valuations and earnings. Put more simply, the benefit from monetary easing would more than offset the negative growth and credit shocks that caused the Fed to ease in the first place.

Here are the potential implications. Let’s face it, if the Fed brings the “bazooka” and fires off enough monetary easing to successfully contain credit risk and support economic growth, then stocks would probably rocket higher. The issue is, this scenario is not very likely. That’s because the Fed is still worried that inflation will heat back up again, and so it’s unlikely to cut rates preemptively. Really, it’d only ease significantly if the conditions were bad enough to warrant it. And in that case, even the bazooka might not be enough to offset the risk of a big, bad recession or of a serious financial accident. There’s a reason why the biggest crashes happen while the Fed is easing: so be careful what you wish for.

Third possible explanation: the economy’s in danger, but the trouble is concentrated with smaller firms.

Goldman thinks a third explanation is more likely. If financial stress is high enough to force the Fed to cut, but concentrated enough so that it doesn’t spread everywhere, then some companies may escape intact. In fact, the ones that are not in the eye of the storm – most likely larger companies – may even benefit from the Fed’s easing. That’s what we’ve seen over the past two weeks, with sectors emerging as big losers (financial and real-estate firms, for instance), and others emerging as big winners (like tech firms and, to a lesser extent, consumer discretionaries). Going back to the first chart, that may explain why the Nasdaq performed so well and why the small-cap Russell 2000 performed so badly. As for the S&P 500, it’s got a big concentration in some big tech companies, which may explain why it remained so resilient and why its volatility hasn’t exploded higher.

Here are the potential implications. If this is what’s happening, then stock investors may not be as over-optimistic as it may seem, and may be pricing the risks appropriately. And as long as there’s no further contagion, stocks could continue to do well. That being said, it’s arguably a very thin line, as a shock that is large enough to force the Fed to ease is likely to significantly raise the risks of contagion and other bad things. And sure, you could bet on the sectoral dispersion to continue, but it’s hard to imagine large-cap stocks rising too much while small-cap stocks are sliding.

And what’s the opportunity then?

Any one of these explanations – or even a combination of the three – could be true. But in each of these cases, stocks are pricing in a much rosier scenario than other markets. That doesn’t mean that stock prices won’t rise if the risks subside, but they’re certainly more vulnerable if they don’t.

In fact, if you were considering buying stocks on the basis that the Fed will ease, you might want to tread carefully. Not just because of what’s already priced in, but also because an environment where the Fed cuts interest rates is unlikely to be a great one for stocks. And hoping that it’ll be enough to offset credit and growth risk (explanation 2), or that contagion will remain limited (explanation 3) involves a lot of assumptions and uncertainty.

If you do think the economy’s robust enough to resist a recession and that the financial system is safe, then buying commodities, emerging market currencies, and small-cap stocks could be a better trade, compared to large-cap stocks or tech stocks, given they have more catching up to do.