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4 reasons why the stock market is rallying even as coronavirus drags down the US economy

Mike Santoli.
Adam Jeffery | CNBC

Bad economic news doesn't always translate to a rough time for the U.S. stock market. Even as the coronavirus-induced shutdown has shocked the U.S. economy, the market has appeared pretty resilient. 

Unemployment has hit 14.7%, the highest rate in about 80 years. And gross domestic product (GDP) — which experts rely on to determine the health of the economy — shrank 4.8% in the first quarter of 2020 — another decline the likes of which we haven't seen since the Great Depression. Yet in April, the S&P 500 logged its best month in 33 years and had its best rebound since 1938. That's especially notable because traders view the performance of this benchmark index as a barometer for the overall health of the U.S. stock market.

CNBC's senior markets commentator Michael Santoli, who has been covering Wall Street for more than 20 years, says there are four things new traders need to understand about how the stock market is behaving in response to the coronavirus pandemic — and why the market sometimes rallies on bad news

1. Traders are forward-looking

Traders accounted for the potential toll of the pandemic at its onset, Santoli explains. "The stock market fell 35% in a month's time from late February to March 23, as the full effect of the stay-at-home orders were realized. This was the fastest drop in the S&P 500 of that magnitude from an all-time high ever."

So when the Labor Department released historically high unemployment data on Friday, May 8, and the S&P 500 closed out the day 1.7% higher, it's not necessarily because traders were ignoring the news. It's because they had already been anticipating that impact months ago, which was reflected in the stock market's decline in late February and early March. 

"The market rushed to price in the expected economic damage, falling about as much as stocks have in a typical recession," Santoli explains. 

The aftermath of the financial crisis, which officially lasted from December 2007 until June 2009, illustrates Santoli's point. During the financial crisis, stocks hit their lowest levels on March 9, 2009. But by the end of September that same year, the Dow rose nearly 50% and the S&P 500 was higher by 56% from that low.

Those huge gains occurred leading up to the Great Recession's peak in unemployment, which peaked at 10% in October of 2009.

2. Just 5 stocks make up 20% of the S&P 500

The makeup of the stock market indexes also is important, especially because a few companies have a big impact on the broader benchmark. "Five stocks — Microsoft, Apple, Amazon, Alphabet and Facebook — now represent more than 20% of the S&P 500's value, an unusual level of concentration," Santoli says. 

The S&P 500 is market cap-weighted, meaning the largest companies constitute a larger percentage of the overall index. And unlike many industries ravaged by the pandemic, these tech stocks are thriving. 

Understanding this should help put recent market moves into perspective, Santoli says. "These companies are less vulnerable to declining retail-store spending, the collapse in travel, and weakness in industrial activity from an economic sudden stop. In fact, they're seen as beneficiaries of this work-from-home, online-shopping world."

There are other parts of the market that are more sensitive to employment levels and the strength of the economy, he says. "Mall retailers, auto makers, airlines, restaurant chains have not come back much. The average stock in the market is still 20% below its high price even after the big rebound."

3. Government aid eased investor concerns

The government's response to the pandemic has also helped to mitigate a prolonged decline in the stock market, Santoli explains.

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In March, the Federal Reserve lowered benchmark interest rates to zero, which makes it cheaper for consumers and businesses to borrow money, providing aid to both Main Street and Wall Street. "The Federal Reserve's response has added trillions to financial markets and the economy by keeping bond markets functioning, preventing a wave of corporate defaults and failures, and supporting small businesses," he says. 

Historically, when interest rates are near zero, "that tends to translate into higher valuations for stocks," Santoli explains. Lower interest rates encourage businesses to spend money since borrowing money is cheaper. They can use that borrowed money to invest in growth, like by buying equipment, which in turn, can help increase efficiency and grow profits. 

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Consider that during the financial crisis, for example, the Federal Reserve cut interest rates to near zero in December of 2008, and left them there until raising them by a fraction in December of 2015.

During that seven-year period when interest rates were kept low, the Dow gained nearly 100% and the S&P 500 rose by 126%. 

The Coronavirus Aid, Relief, and Economic Security (aka CARES) Act, also injected more than $7 trillion into the economy. Its provisions included $2.2 trillion worth of direct checks to Americans and expanded both unemployment benefits and forgivable small business loans. It also authorized the Federal Reserve to invest more than $5 trillion into custom-made lending programs. 

"The CARES Act has cushioned the effect on small employers and the unemployed. This has enabled investors to look ahead to the prospects for some kind of recovery in coming months," Santoli explains.

4. Stocks often thrive when things seem 'less bad'

Even though investors priced in much of the anticipated economic damage of the pandemic, and it seems as though the stock market has recovered from its lows, the volatility may not be over.

"The stock market has often done best when things are going from 'very bad' to 'less bad' after a big decline. Doesn't mean the market will be right in assuming a gradual return to a more normal economy, but it's not unusual to see the market trying to look through near-term economic damage," Santoli says. 

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