How can the stock market keep going up despite the awful economy we are in? This is by far the most common question we are hearing from clients right now.
The media tells us that we are in the midst of the worst economic catastrophe since the Great Depression, but the stock market is close to all-time highs. What gives? How can there be such a large disconnect between the economy and the stock market? The simple answer is, “we don’t know.” Anyone who claims to know why the market is going up or down is lying to you. The best I can do is give you five plausible reasons why this is occurring:
This is a favorite mantra at our firm. There is so much evidence to suggest that the stock market and the economy are disconnected. Remember, the stock market is trying to predict what will happen in the future, while the economic news tends to be focusing on what has already happened. The chart below looks at the US GDP growth, widely thought of as a barometer for the economy, versus the S&P 500 return, broken out by decade:
As you review the data, what becomes increasingly obvious is that GDP growth has very little correlation with the stock market’s return. Take the last two decades as an example. While GDP growth has been nearly identical, stock market returns have varied significantly. Understanding this data helps you understand that the stock market can perform well even in the midst of a bad economy.
2. The largest stocks that significantly influence the markets are actually doing well
2020 has seen some of the largest variances in returns between sectors, industries, and styles of stocks. For example, through August 7th of 2020 US large-cap growth stocks have experienced a return of 20.79%, while US small-cap value stocks are down -16.75%. Here is what’s interesting…the 5 largest large-cap growth stocks make up 23% of the S&P 500. Knowing that, take a look at their returns year-to-date through 8/12/2020:
So here is what’s happening. The largest companies are all benefiting from the pandemic. These technology companies that most people rely on more than ever have had gigantic returns so far this year and are pulling up the entire market into positive territory. In fact, through July, nearly two-thirds of the S&P 500 were in negative territory, but the index is now positive because of the significant weighting of the five companies listed above.
3. The economic disruption from COVID is temporary
Will COVID permanently change Apple, Walmart, or Exxon Mobil’s earnings? Perhaps, but an alternative is that the challenges we face from this virus are temporary, and at some point, we will go back to an economy and life where things look similar to our pre-COVID days. If you believe that narrative, then the behavior of the stock market may not be a surprise. A common valuation method analysts use to determine the fair value of stocks is called the discounted cash flow method. This method estimates the present value of all future cash flows from a company to determine their fair value. If you expect cash flow to be temporarily depressed and then returning to normal, the discounted cash flow method will not change the valuation of stock significantly since one or two years of smaller cash flows is a minor variable in a model that assumes perhaps a decade or more of future cash flows.
4. Fiscal stimulus
World governments took unprecedented action to combat the economic impact of this virus. Between additional government spending and loans, the world has seen an additional $9 trillion pumped into the global economy. This additional stimulus has helped offset the crushing job losses that came with the global lockdowns to combat this virus. While it is hard to believe this stimulus will go on forever, the additional government spending has helped companies keep workers employed and assisted households to stay afloat. These actions have also buoyed corporate revenue and earnings, which may contribute to why stocks have not seen the losses many would have expected.
5. Job losses today have not hit overall income as hard as in other recessionary periods
The ability to telework has allowed many higher-paying jobs to continue during this pandemic. While only 9% of employees without high school diplomas were able to telework, 62% of college grads found telework an option. This means that job losses were heavily focused on less-educated workers. Therefore, even though overall job losses were catastrophic, the total income lost was not as impactful had the losses been more widely spread amongst the workforce.
No one knows what the future will bring. And while it’s difficult to explain why the stock market behaves as it does, one thing we are steadfast about is that the markets work. The millions of buyers and sellers that come together every day and set the stock price show us the best representation of a company’s value. Our recommendation, as always, is not to try to fight this. Accept market pricing, make sure your portfolio has the right level of risk, and then let the market do what it has always done for those with patience: create wealth.
 GDP data source= Federal Reserve Bank of St Louis, S&P 500 data source= DFA Returns Web Program
 US Large Cap Growth= Russell 1000 Growth, US Small Cap Value= Russell 2000 Value
 Data source= Google Finance 1/1/2020 to 8/12/2020, share price return only