The New York Stock Exchange (NYSE) is seen in the financial district of lower Manhattan during the outbreak of the coronavirus disease (COVID-19) in New York City, U.S., April 26, 2020.

Jeenah Moon | Reuters

The coronavirus crisis is unprecedented in modern times, the near-global lockdown a wholly new kind of societal shock.

Yet as novel as the experience is in detail, the markets continue to fight old, familiar battles as investors try to handicap an unusually wide range of plausible economic outcomes.

Specifically, the S&P 500‘s powerful rebound rally was thwarted last week right in the zone of important prior peaks; the market continues to struggle with dependence on a handful of dominant, richly priced growth stocks; and equities remain tethered to the credit markets, with bond investors deciding how long the leash.

Last Wednesday, the S&P hustled to a high of 2939, traders seizing on any hints of progress against Covid-19 and celebrating government financial support that together could cushion the lockdown’s impact and shorten its duration.

That day saw a favorable Gilead antiviral-drug trial and an affirmation by Federal Reserve Chair Jerome Powell of aggressive, open-ended liquidity support for the economy. Coming right near the end of the best monthly gain in 33 years, the move could be seen as a short-term culmination of the relief rally.

That S&P level, just above 2930, was almost exactly where the S&P crested in September 2018, preceding the nasty 20% recession-scare decline and effectively capping the market for the next ten months. By Friday, the index had slipped back below 2872, which was the euphoric top from January 2018, as Wall Street celebrated the big corporate tax cut just passed.

There is no deep, inherent significance in these familiar index values, no magic market muscle memory that flexes as they are revisited. Though in this case, the level was right where the index regained just more than 60% of its total losses, often an area where rallies pause or reverse.

Former highs also provide convenient places to assess conditions now compared to when last the market was here and failed. In early 2018, the S&P rose to 19-times forecast earnings, as the tape priced in expectations of 20% profit growth in an economy reaccelerating near full employment. In September 2018, those earnings had come through, credit markets were flush and the forward P/E had dipped to 17.

Today, the outlook is foggy, 2020 will see a steep drop in profits and investors are reduced to penciling in some range of 2021 profitability after a retrenchment of undetermined depth and duration. So, it’s perhaps no wonder the market didn’t manage to push above those old levels on the first trip.

Reliance on tech

The S&P’s reliance on the largest, most potent growth companies in technology has been see both as a virtue and a vulnerability of this market for years. It remains so.

Both before the February peak and after the panicky market low of late March, the popular giants of the Nasdaq (Microsoft, Apple, Amazon, Alphabet and Facebook) outperformed the market handily. The market rationally was privileging dominant digital platforms with stable long-term cash flows in an iffy economic environment.

As noted here last week, these names along with outright defensive consumer staples stocks held the index together as shares of cyclical, smaller and highly indebted businesses suffered.

This divergence — the five tech leaders collectively worth more than 20% of the S&P 500 trouncing the typical stock — grew stretched enough that a snapback rotation was unleashed early last week, just as investors started trying to focus on the “reopening of the economy” theme.

The Russell 2000 surged 10% Monday to Wednesday, but couldn’t sustain the advantage, buckling along with the big tech bellwethers to finish even with the S&P on the week.

This erratic interplay between large and small-cap benchmarks in recent weeks is visible in this Bespoke Investment Group chart of Russell 2000 vs. S&P 500.

Source: Bespoke Investment Group

A rally is nor more valid or durable when smaller stocks lead, and the steady underperformance of small stocks for most of the past few years has mostly been a footnote to a bull market. But the whippy relative price action among sizes and styles of stocks — growth and value, momentum and mean-reversion — shows rapid, low-conviction tactical repositioning in a fundamentally opaque environment.

Credit markets key to equity markets

The credit market, as ever, has permitted and underpinned the equity revival. The Fed’s trillions in liquidity injections to keep the fixed-income market functioning and its vow to buy corporate debt as needed put a floor under stocks and touched off a corporate-bond issuance wave. April saw a record volume of new investment-grade debt sales, with much of it to companies simply piling up cash to cover costs through the lockdown.

Canaccord Genuity’s Tony Dwyer says, “The historic surge in new issuance suggests companies should be able to stay in business and weather this storm…The recent investment-grade and high-yield corporate debt spread has improved dramatically from the worst levels of March following the explicit Fed support, but both areas remain stressed relative to other periods of sustainable growth.”

Citi strategist Tobias Levkovich adds, “The Fed’s willingness to take in junk bonds as collateral has helped the US equity market by virtue of high yield credit spreads narrowing, but that now is behind us, unless one wants to believe that the Chair Powell will call for the central bank to buy stocks, which we consider a bridge too far for policy makers. Thus, we suspect that the good news is priced in with the S&P 500 only down 10%+ year-to-date now despite what may be the worst jobs environment since the Great Depression.”

 These concerns are being aired as the ferocious 35% rebound rally spilled back about 4% from its Wednesday peak by week’s end. The force of the rally leaves plenty of room for further pullbacks and choppiness without bringing the March lows into clear view.

 Yet with the central-bank backstop widely embraced, and investor sentiment and positioning rushing from despondently defensive to relievedly neutral, much further upside from here probably requires more substantive indications of successful resumption of economic activity rather than just feints in that direction.

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