We are currently in one of the most difficult economic environments many of us will see if our lifetimes. Even though the unemployment rate has fallen from its high of 15% to a level to closer to 10%, it still exceeds the peak from the 2008 crisis, which itself was one of the deepest recessions ever. Small businesses and entire industries, like air travel, cruise lines and hotels are struggling mightily as the various degrees of lockdowns we have experienced in recent months have taken a huge toll.
But despite all of that, the stock market currently sits at all time highs. I don’t think there has ever been a point in my career where the disconnect between what the market is doing and what your average person is seeing in their own lives has been greater than what we are seeing today. Some experts think this is a sign that the market is a house of cards that is inevitably going to collapse, while others see reasons to justify what is going on, but either way I think it is important for all of us to take a step back to try to understand the reasons for this bifurcation and the lessons we can learn from it. So I wanted to use my article this week to look at some reasons why this disconnect between the stock market and the economy has occurred.
Here are some reasons why the market is at all time highs, despite the economic conditions we face:
The Stock Market Isn’t the Economy
We all have a tendency to look at what is going on in our own lives and to expect the stock market to follow that. If we are doing well, and we see our neighbors doing well, we expect to look at the stock market and see it doing well. And if we are struggling, we expect the market to be struggling. But that often isn’t the way things work.
Although the stock market and GDP both are positive trending over time, they can also disconnect from each other for extended periods.
There can be periods where the stock market does well and the economy does poorly, and vice versa. Although the magnitude of the disconnect right now may be extreme, the market and the economy becoming disconnected from each other is nothing new.
The Industries We See Most in our Everyday Lives Often Aren’t the Ones That Impact the Market Most
Barry Ritholtz wrote an excellent article recently for Bloomberg about this. Here is how he explained it:
“the most visible and economically vulnerable industries are also among the smallest, based on their market-capitalization weight in major indexes such as the S&P 500,” adding that “markets, it turns out, are not especially vulnerable to highly visible but relatively tiny industries.”
It is easy to see how much the airlines and energy companies and the retailers we see in the mall have struggled because of the pandemic. But they represent a much smaller portion of the S&P 500 than people think. The companies that represent the largest share of the S&P 500 are mostly technology firms like Amazon and Apple and Google that have not only avoided losses due to the pandemic, they have actually benefitted.
The Government Has Injected Massive Stimulus into the Economy
The magnitude of the recent government stimulus is certainly unprecedented, with trillions of dollars having been pumped into the economy. But the nature of the stimulus is even more important than the magnitude. The quantitative easing conducted by the Fed in recent years didn’t have much impact on the economy since the money never made it into the hands of everyday people and businesses. The programs adopted in the wake of the coronavirus are very different since they have included significant fiscal stimulus. Things like direct checks to individuals, extended unemployment benefits and the Paycheck Protection Program put money directly into the hands of people and businesses. Much of that money made its way into the actual economy. Some of it was even used to buy stocks. This will have a much greater impact on the economy than the monetary stimulus programs of recent years. I won’t argue the merits of these programs or their long-term impact here, but the short-term impact has clearly been substantial.
Much of the Value of Equities Lies in the Future
It is important to keep in mind that the value of a company is the present value of its future cash flows. And equities are very long duration assets, so those cash flows are measured over a very long period of time. When you look at things from that perspective, the cash flows a company will generate in the current year are likely something like 5% of its long-term value. So for those who view this as a short-term event, it can be argued that the impact on the market shouldn’t be nearly as great as current economic conditions would dictate. Obviously, for those who think this will impact earnings for years to come the situation becomes very different, but either way it is important to keep in mind that long-term cash flows are far more important than what happens this year.
Behavior Can Trump Fundamentals in the Short-Term
When the stock market gets on a run, we all have a tendency to get caught up in it. Making money in the markets seems easy at times like these and everyone wants to jump in due to their fear of missing out on the easy gains. This can lead a market to become disconnected from its fundamentals over the short-term. Rob Arnott gave a great interview on the Bloomberg What Goes Up podcast recently where he offered the following two criteria to define what happens in a bubble.
(1) valuing an asset based on discounted future cash flow requires you to use implausible assumptions to justify the current multiple; and
(2) the marginal buyer doesn’t care at all about valuation models.
I will leave it to you to decide whether what we are seeing now constitutes a bubble, but either way it is important to keep in mind that investor behavior can lead the stock market to become disconnected from economic fundamentals.
How Does This All End?
I have never been one to try to predict where the stock market is going in the future, and I am not going to change that now. I am typically a very logical person and I admit that I have a tough time justifying what the market is done given the economic issues we all face. But it is also important to keep in mind that the stock market is often smarter than all of us. Although it might seem unlikely that we could go through an economic situation like this without a more lasting impact on the stock market, it is certainly within the realm of possibility. But it is also possible that the economic reality will be worse than expected and the stock market will eventually suffer the impacts of that. Which path we will take is beyond my pay grade. But either way, it is important to keep in mind that the path the economy takes will not necessarily be the same one taken by the stock market. We have all learned that lesson in 2020.
Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.