A popular question from investment media this month is how stock markets can only be down 10% to 15% from their pre-COVID highs amid all this economic damage.
On May 10th, the New York times published an article called Repeat After Me: The Markets are not the Economy. On May 22nd, the Globe & Mail Markets released an article titled Markets leave the economy behind: The Globe’s investors’ guide to help you navigate pandemic-roiled markets. Both articles aim to explain the disconnect between markets and the economy. The reasons provided are as follows:
- Markets are forward-looking. This has been discussed many times in the past. Since markets tend to be forward-looking, investors have already accounted for what is expected to be a large drop in second-quarter earnings and are projecting a relatively rapid economic recovery afterward. The stock market does not know good or bad, it only knows better or worse. Things were getting worse in late February and throughout the month of March, and things have been getting better since the end of March. The U.S. Federal Reserve’s stimulus package has also increased investors’ confidence that the bottom will not fall out of the market.
- Companies on Wall Street and Main Street are very different. Publicly traded companies are larger, more profitable, hold more cash, have access to bond markets, and are more global than the typical American family firm. About 40% of the revenues of S&P 500 companies come from abroad.
- Index concentration. The S&P 500 Index measures the performance of 500 large companies traded on U.S. stock markets. It is a market-capitalization weighted index, meaning the companies are weighted according to the total market value of their outstanding shares. Therefore, the index is weighted to reflect the performance of the largest and most profitable companies. In recent weeks, the five largest listed companies — Microsoft, Apple, Amazon, Alphabet and Facebook — have continued to climb this year and currently make up 20% of the entire index. Through the end of April, these companies were up roughly 10 percent this year, while the 495 other companies in the S&P were down 13%.
- Stock ownership. Stock ownership is heavily biased to the richest segments of the population, who are least likely to feel the pain of an economic downturn.
- Crisis specific reasons: In a typical business cycle, a strong economy eventually overheats and generates areas of excess production capacity, which can take years to rebalance once a recession takes hold. For example, rampant U.S. home construction and subprime mortgage securitization led to the 2008 global financial crisis, and excess spending on technology fuelled the 2008 dot-com bubble. The COVID-19 health crisis has placed the brunt of the downturn on the services industry, which will not have the same excesses to work through.
The notion of markets versus the economy is timely and will likely be covered extensively in the months and years to come. Despite the above pro-market explanation, the usual disclaimers and risks continue to apply. The markets are forward-looking, but not all-knowing. A significant second wave of infections or delayed treatment timeline could potentially cause another market shock. The size and scope of government and central bank stimulus is historically untested and could have side effects in the years to come.
Given this backdrop, we continue to believe investors are best served by staying true to their financial and retirement plans and constructing a diversified portfolio of high-quality equities and fixed income.