The market rally that investors have watched since the end of March finally began to wobble in June. After the S&P 500 picked up more than 18% during the first two months of the second quarter, June’s return was good at 1.99% but meager compared to the first two months of the quarter. It wasn’t just that the rally lost steam—it was downright volatile at times during the month. Only half of the 22 trading days in the month had a daily return less than 1% positive or negative, and June 11 saw a particularly volatile day with the S&P 500 losing 5.89%. Mid- and small-cap indexes had disappointing finishes after seeing huge runs during the end of May to beginning of June period. The Russel 2000, a small-cap index, picked up 24.76% from May 13 through June 8, but subsequently lost 6% through the rest of June. The index finished the quarter with an impressive 25.42% return for the quarter.

The primary cause of heartburn in the market has been continued uncertainties around COVID-19. The second wave appears to be arriving as new hotspots emerge around the U.S. and the rate of new confirmed cases is increasing at a faster pace than the country saw at any point earlier this spring. By the end of June several states announced that they were either pausing their reopening process in its current phase or, in some cases, rolling back reopening measures to promote more social distancing. The pandemic’s economic disruption has been driving the narrative since February, and there is no reason to expect that will change in the next several months.

Also contributing to the amount of market volatility in recent weeks is the growing chance of a Democratic sweep in November. The race between Biden and Trump has been considered by most to be a toss-up, but until recently the prospect of the Democrats keeping the Senate and taking control of the House has been viewed as unlikely. We all learned in 2016 that polls aren’t the same as elections, but they still provide us as with information and this data has not been positive for Republicans recently.

Given the market’s distaste for uncertainty, it has been interesting to reflect on why the rally has been as strong as it has. The likeliest answer is simple and unsettling: The Fed. The Fed’s balance sheet crossed over the $7 trillion threshold in mid-May and shows little signs of slowing down. Compare this with its level of $3.8 trillion in September 2019 or even with the previous high of $4.5 trillion seen before the Fed ended quantitative easing in 2015. It does not seem farfetched at all, at this rate, for the Fed’s balance sheet to eclipse $10 trillion in the next 6-12 months. This would be approximately half of the entire country’s annual GDP. It’s not just a matter of how much the Fed is buying in the open market, either—what the Fed is buying is also likely a big contributor to why the market has rallied so strongly. In the Great Financial Crisis (GFC) of 2008 -2009, the Fed limited its quantitative easing program to the purchase of government bonds and mortgage backed securities. In the current crisis, the Fed has begun to buy corporate bonds in addition to those operations. At first this was limited to buying corporate bond ETFs on the open market, but in mid-June the Fed announced that it would begin buying the bonds of individual companies. This represents a big step from simply providing liquidity to the overall bond market to supporting the credit of publicly traded U.S. companies. At this point the Fed has not announced plans to purchase stocks. If the economy’s situation grows increasingly dire, for example as a result of worse than expected outcomes related to COVID-19, stock purchases by the Fed would be one of the remaining tools left available.

As we are already in unchartered territory with Fed activity, any additional measures from here on would be difficult to judge in real time. On the one hand, it’s admirable that the Fed has taken such swift and robust action to stabilize capital markets following the shocks from this pandemic, especially in contrast with the gridlock we’ve come to expect from Congress. When your house is on fire you shouldn’t worry about the water supply you’re using to extinguish the flames. On the other hand, monetary stimulus is akin to a drug from which markets will have a very difficult time weening. Recall that the Fed did not begin to let bonds roll off of its balance sheet from the GFC until the middle of 2015 and that it held rates down at zero until the end of 2015. Market turmoil ensued before that point whenever the Fed signaled the help would stop. If we’re lucky enough to experience swifter economic recovery now versus a decade ago, will that allow the Fed to unwind its stimulus faster? Or will the sheer scope of today’s actions necessitate an even longer off ramp?

While understanding the long-term impacts of the Fed’s actions will be difficult, we can be confident that in the near-term it is one of the main factors propelling the stock market. As of June 29, the forward price-to-earnings ratio on the S&P 500 was 21.42. This is more than 1.5 standard deviations above the long-term average of 16.4 and a level not seen since the early 2000s. As long as the Fed continues to signal its willingness to do whatever it takes to get the country through this disruption, markets could very well go higher, even in the face of negative pandemic developments. But if markets begin to sense that the Fed will get stingy with the money pump, then investors may get a rude awakening.

We have always advocated against attempting to time the market, and our advice is not any different at this time. However, if you are an investor who realized in March that you may be taking more risk than you’re comfortable with and have been waiting for things to recover before changing your portfolio, now may be a good time to do so.

Get Monthly Insights Delivered to Your Inbox

Subscribe to our Investor Insights Newsletter today and get insights like these delivered directly to your inbox each month.