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The Disconnect between The Stock Market and The Economy

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(The Golden Gate Bridge, San Francisco, California - Jeff M. Wang)

 

 

- Economic Data Looks Backwards, But The Market Looks Forward

First, and perhaps most significantly: even in normal times, economic data looks back and the stock market looks ahead. By definition, a recession is looking back to the last six months or more. So by the time devastating economic data is released, the market has typically long been pricing it in. From there, it’s essentially just a question of whether the data was aligned with market expectations or not.  

The economy is complicated and it moves fast. News breaks and headlines don’t always tell the whole story. Usually, this simply means that fluctuations in the markets may have little to no real bearing on the underlying realities we think of as making up the economy. Or that there are many important structural factors that make the markets’ outlook different from how ordinary citizens view the country’s overall economic health.  

In the time of COVID-19 (year 2020), the stock market couldn’t be more divorced from the United States’ broader economic situation. Although the S&P 500 tumbled sharply in March, 2020, as the coronavirus shut down large swaths of the economy, it had made back almost all of its losses by the first week of June - before dipping again and then quickly rebounding yet again.

Even if it takes a year (2021?) to get a vaccine out, that’s not terribly long for the stock market. It is for all of us stuck at home, but in stock market time, it’s just not that long. A company’s cash flows over the next 12 months is only a small piece of the value of the stock. And that’s what you’re paying for when buying a stock: the company’s future cash flows. 

From a historical standpoint, P/E ratios (price to earnings) are still high. The forward P/E ratio is 20.5x. Over the last 25 years, the average forward P/E ratio was over 16x earnings. In either case, the next 12 months of earnings is only worth a fraction of the value of the stock (1/20th vs 1/16th).

 

- Monetary And Fiscal Policy Measures

For example, the monetary and fiscal response to the COVID-19 crisis has had a lot to do with the market recovery from recent lows. The cumulative relief packages dwarf what we saw in 2008 and that’s before a proposal this week which would add $3 trillion more. The Federal Reserve has injected a tremendous amount of liquidity in the market: they’re buying bonds and helping maintain liquidity in the money markets and supporting the flow of commercial paper to businesses. 

Liquidity is important because it gives investors confidence that they can access credit or trade a security. When there’s no liquidity, you may not be able to find a buyer if you’re trying to sell a bond for example. Setting the target range for interest rates near 0% has also supported market confidence.

 

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(MIT, Yu-Chih Ko)

- Low Bond Yields Make It Harder To Turn Away From Stocks

Even beyond the markets, there has been some data to suggest that the worst fears about the economy in late March and April, 2020 were too pessimistic. But the overall state of unemployment is still quite bad by historical standards, which mirrors numerous important economic indicators that are almost uniformly down - to a significant degree - from last summer (year 2019). And yet stock indices continue to rebound much faster than the rest of the economy.

Why? As is usually the case in economics, it’s complicated - and everyone has a pet theory. A few include:

  • The idea that investors are betting on a quick “V-shaped” recovery (rather than the longer, slower “swoosh” shape many economists have predicted) and banking on corporate profits eventually rebounding in the medium and long run. 
  • Some prominent tech companies at the top of the market (such as Microsoft, Apple and Alphabet) actually have reason to think the pandemic could shift business in their favor, with so much emphasis placed on digital shopping, communication and entertainment. 
  • And the rise of algorithm-based trading has insulated markets somewhat from the shocks that could be created by big news events, such as political developments or the protests against racial injustice currently sweeping across the country, since dispassionate algorithms don’t get worried or scared by the news the way humans do. 
  • The markets are also providing a better place for wealthy people to stash their money than alternatives like bonds or banks. People, particularly the rich, have cut back their spending, so they need to park their funds somewhere like the stock market especially since interest rates are rock bottom, 
  • Inequality can mean that even with millions out of work, there might still be a glut of funds from the high-earning and/or high-wealth individuals. The yield on Treasury bonds is so low that stocks are an attractive option - even in the midst of a recession caused by a once-in-a-generation pandemic. 

 

Recent stock market performance (July, 2020) could be more about something like a savings glut rather than optimism on the future value of companies. It may be more about the S&P 500 being better than anywhere else to put funds rather than about actual optimism. That doesn’t necessarily mean there’s no optimism driving investors’ actions, though. Maybe people are investing for the longer term and are viewing the current economic situation as substantially temporary. And it’s worth noting that, despite everything, the markets are not totally separate from the virus that continues to afflict every corner of the world. 

 

- The Market Hates Uncertainty More Than Bad News

The stock market has entered a period of massive uncertainty resulting in near-record volatility and rapid losses. When news of the coronavirus (COVID-19) first hit, the VIX - a measure of market volatility perhaps better known as the “fear index” - spiked to 82.7, its highest level ever. (The previous high was 80.9, which it hit in November 2008, when the Great Recession sparked a massive selloff.) News of a COVID-19 resurgence earlier this month caused the VIX to surge to 40.8, another abnormally high number -outside of recessions, the VIX usually floats between 10 and 20. Despite the rising indices, uncertainty rules the stock market right now. 

Fear and uncertainty abound over the current and future implications. What that means down the line is anybody’s guess. But for now, Wall Street has shown a shocking amount of resilience even as almost every other economic indicator has tanked. If nothing else, let this be the final confirmation that, once and for all, the stock market is not the economy.

 

 

[More to come ...]



 

 

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