Why is the Market So Disconnected from the Economy?
Hey guys, Mike Frontera here back with another Retirement Theory video. Well this has no doubt been one of the most surreal years that I can remember. The Coronavirus pandemic has turned so much of what we consider normal life right on its head. Jay Leno had made an appropriate joke – he said “I got in trouble at the bank the other day. I was the only one not wearing a mask!” ….But seriously folks.
Well for most of us, Coronavirus has been no laughing matter. And putting aside the obvious health risks and the many people we’ve lost from this virus, the toll on the economy has also been astronomical. In states all across the country thousands of businesses have been forced to close down for weeks or months. Only to be followed by painfully slow and heavily restricted reopening plans. And this crippling economic situation is playing itself out in various degrees, really all around the world.
Which is why it’s absolutely puzzling to so many people why we’ll hear on the very same newscast, telling us about cities never returning to normal and Great Depression-like unemployment, that the S&P 500 just hit a record high. And that the NASDAQ has been hitting record highs since June!
Somebody please explain what’s going on here!
Well the good news is it isn’t magic. In fact, it’s not even terribly surprising. In fact there are 3 perfectly logical reasons why we’re seeing this illogical scenario play out.
First: The Market is not the economy. You’ve may have heard this before as an exression. And it’s true to a large extent. One way it’s especially true is what we’re actually identifying when we say the “market”. Think about it for a second.
What does the “market” mean? What does the “stock market” mean? Well, for a lot of people it’s what they see on the news whenever they do the market recap. Basically, the three most reported on stock market indexes: The Dow Jones Industrial Average, the NASDAQ and the S&P 500.
All three are what are called “cap-weighted” indexes, meaning the larger the company in the index, the bigger a percentage of the index it makes up. So what we’re really looking at are some of the largest companies in the world and even then, it’s skewed heavily toward the largest of those.
Let’s start with The NASDAQ. As of July 22nd, just 6 companies: Apple, Microsoft, Amazon, Facebook, Google (Alphabet), and Tesla made up about 41% of the NASDAQ. In an index that has more than 2700 stocks.
How about the Dow Jones Industrials? Here again, we have just six companies: Apple, United Health Group, Home Depot, Microsoft, McDonald’s and Visa making up about 42% of the index.
And the S&P 500? Their top six stocks: Apple, Microsoft, Amazon, Facebook, Google and Johnson and Johnson make up just about 25% of the S&P 500, despite the index having 505 member companies.
You may have noticed a lot of overlap here and that most of these companies are involved heavily in technology. As we’ve quickly fast-forwarded progress on remote working, shopping, delivery, almost every part of our daily lives, tech companies have been a huge part of that.
So the first reason is that when we’re looking at we consider the market, we’re truly not looking at the economy as a whole. Instead we’re mostly looking at largest corporations within the economy and even then we’re looking heavily toward those that have benefited from our heavier reliance on technology. To say it succinctly, what we informally call the stock market does not represent the full economy.
The second reason why stocks are disconnected from the economy is that when we buy a stock, we’re generally making a prediction of the future, rather than a reflection of the present. In other words, most logical buyers of stock are hoping for the price of that stock to go up in the future. Let me give you a quick example:
Which stock would you rather buy?
Stock 1, of ABC Company, who’s had a great history of profits and is one of the most recognizable companies in the world. But you just heard on the news that the CEO is under investigation. He’s allegedly orchestrated a scheme that sells its customers' private data to a foreign government in exchange for billions of dollars in large project contracts.
Or company 2? Who’s had decent revenue but hasn’t yet reached profitability. But, they just announced a ready for market new battery. This battery can drive a car across the country on a single charge, or power homes and businesses for a tiny fraction of what people are used to paying.
Despite the less attractive current financial situation for company 2, we'll call XYZ, I think most of us would prefer purchasing the stock of that company, assuming that the future appear much rosier than for ABC. And so it goes for the stock market. People buy based on what they think will happen, not on what is happening right now.
So then it stands to reason that the market is pricing in some amount of optimism about the recovery of the economy in the somewhat near future. Should news develop that would be counter to that, the market would likely react by selling off.
And as we’ve just seen, the markets react fast to news. The news of Coronavirus and the ensuing shutdowns sent the S&P 500 down 34% in just over a month, from February 19th to March 23rd. During that there was a lot of speculation about how bleak the economy would get and to what degree governments would step in and support the economy during that time was largely unknown.
As that support came in and the prospects for truly dire situations started to dissipate, investors began putting money back into stocks. While future pain in economy is expected, that anticipated pain has already been largely factored into those current prices. It is more the change in that anticipation that would likely alter prices going forward.
This brings me to the third reason between the disconnect between the stock market and the economy. And this reason ties to the previous two pretty strongly. That is, we have had a tremendous level of support from our government and the Federal Reserve to keep the economy functioning somewhat normally during this time. And the expectation is that this support will continue as needed until the pandemic largely subsides.
So I kind of opened a huge can of worms there by saying government and Federal Reserve “support”. There are a number of areas where support has been given, mostly all of which have been deployed rapidly and on an unprecedented scale. The proverbial kitchen sink of tools has been thrown at this problem.
Unemployment for example shot up over 14% almost instantly during the initial forced Covid shutdowns. Directly following some historically low unemployment numbers to boot. Just looking at the unemployment chart is visually striking.
However, emergency unemployment benefits were quickly passed, granting Americans an additional $600 per week in benefits. Add that to existing state benefits, and many people who would otherwise found themselves in immediate financial trouble found themselves making more than they were when they were working!
Business were granted relatively easy loans, some of which were entirely forgivable just to keep people on payroll.
Finally, let’s talk a second about interest rates. The Federal Reserve bank almost instantly lowered short-term rates to just about 0 during the early days of the pandemic. And you just can’t underestimate the power of low interest rates.
Now, if you’re going down the Retirement Theory video rabbit hole, which I think you should, I recommend watching “Who is the Fed and Why They’re so Important” https://retirementtheory.com/retirement-blog/who-is-the-fed-and-why-theyre-so-important.
If you don’t have the time to watch I’ll give you three quick ways that lower interest rates helps stocks.
- The direct impact. Stocks prices are generally thought of as the present value of all future cash flows. And this calculation uses interest rates to determine how much to discount those future flows. Bottom line is that lower interest rates leads to less discounting and consequently higher prices for stocks, all else being equal.
- This is also a big one. It makes other assets likes bonds, CDs and money markets all less attractive versus buying stocks. As of the end of July a 10-year treasury bond pays just 0.55%. Obviously much safer than stocks, but questionably attractive for an average investor to plunk down serious cash for 10 years in order to get a little better than a half a percent interest.
- Third is that so much business is conducted on credit. From mortgages to business loans, all loans suddenly get cheaper. That means a business can borrow more money for the same interest cost or conversely with the same level of borrowing can enjoy a healthier bottom line.
So this drastic reduction in rates, which already were at low levels, was just one more shot in the arm of the stock market and ultimately the economy.
Finally we of course still don’t know where things go from here. The virus could have a bigger effect than was expected or it could suddenly become yesterday’s news with the advent of an effective vaccine or treatment. We can all expect though is that stock investors will continue to attempt to anticipate the future of the economy long before what actually happens in the economy comes to pass.
So! Do you have questions for me? Let me know. Come visit me at www.retirementtheory.com or send me an email at firstname.lastname@example.org. Did you click subscribe on this video or follow me on Facebook? I think that you should. You’ll continue to see videos like these on everything retirement planning.
Once again, thank you for joining me, take care of yourselves, and we’ll see you next time!