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Why is the stock market going up when the economy is in trouble?
If you’re an investor, this question has likely been on your mind. After all, we’re in the middle of the scariest pandemic in a century. Some businesses are barely scraping by, while millions of unemployed Americans have relied on enhanced government programs to stay afloat – yet the markets are hitting new highs.
To understand the disconnect between the markets and the economy, it’s helpful to understand what defines the U.S. economic system and the stock market.
The economy is the system under which money, industry and commerce are organized. Economic health is measured by employment and production growth. The system in the U.S. is considered capitalistic, driven by supply and demand, with a mix of government involvement and socialist-type policies such as Social Security and Medicare.
The stock market refers to a public marketplace in which stocks and other financial instruments are bought and sold. Stocks represent shares of a portion of ownership of a company. The stock market is frequently represented by the S&P 500, an unmanaged index representing the shares of the 500 most important U.S. companies.
To summarize, the economy and the stock market – while related – are not the same thing. This point, along with a few more insights, should not be forgotten by investors:
- Today’s market and economy.
- Stocks are not the economy.
- Why the economy is hurting.
- Why the stock market is going up.
- The bottom line: the stock market and the economy.
Today’s Market and Economy
Troubling economic numbers indicate an abundance of uncertainty at play today.
The August unemployment rate was 8.4%, according to the U.S. Bureau of Labor Statistics. Estimates from the Bureau of Economic Analysis show that gross domestic product, a measurement of all the goods and services produced within the country, was -31.7% in the second quarter. This decline came on the heels of a 5% fall in the first quarter of this year.
Yet as of Sept. 14, the S&P 500 was up 4.73% for the year, including reinvested dividends. Following the terrifying drop for the index in March as the global pandemic began to ramp up, the S&P 500 set an all-time high in August.
This data underscores the complexity between the stock market and the economy.
Stocks Are Not the Economy
In the short term, the stock market’s movements are random and unpredictable.
After a seismic decline in the S&P 500 in March, the market has rebounded and moved into positive territory for the year. The S&P 500 began the year trading at 3,257. To start this month, the market closed at 3,526 – an 8% year-to-date gain. By Sept. 14, the market declined again to 3,383.
There’s more to this stock market versus the economy issue than raw numbers.
“It’s really only a part of the stock market that is doing well, such as the intangible companies like technology and communication,” says Roger Ibbotson, a professor at the Yale School of Management. Right now, many sectors are declining.
According to Yardeni Research, here’s how the worst-performing sectors have fallen in 2020 through mid-September: Energy is down 46.3%, financials are down 18.9%, utilities are down 8.2%, real estate is down 6.3% and industrials are down 3.7%.
On the other hand, a few sectors are prospering. Information technology is up 25.7%, consumer discretionary is up 22.2% and communication services are up 9%. In fact, broad market returns are being driven by a few firms and sectors, Ibbotson says.
Less widely discussed is the shrinking number of publicly traded stocks. The publicly traded stock market is vastly smaller than in the past as many companies choose to remain private and new initial public offerings decline, Ibbotson says.
Over the past couple of decades, the number of public companies has nearly been cut in half – from 8,090 listed in 1996 to just 4,397 by the end of 2018.
Many private companies, both large and small, don’t trade on any stock market. Consider all of the small businesses in your town that have been slammed by the pandemic and region-imposed lockdowns.
It’s clear that major indexes such as the S&P 500 don’t represent the entire economy, as there are many businesses that aren’t represented by the stock market.
Why the Economy Is Hurting
In 2020, demand for goods and services has been severely truncated.
The global health crisis literally shut down travel, entertainment and hospitality as the virus has weighed on consumer demand across sectors. Many industries are hurt because unemployed and lower-paid workers lack the resources to spend their income. This curtails demand for many goods and services from hospitality to real estate.
Even consumers who have jobs are impacted by the crisis and may not be spending as much as in the past. When citizens are out of work completely, and buyers for goods and services diminish, it’s expected that the economy will suffer.
Adding to the troubled economy are the government-imposed closures and quarantine recommendations designed to limit the spread of the virus.
This lack of demand is having a ripple effect across the economy. Despite some companies and industries growing, there are many others that are struggling in this unprecedented environment.
The federal government’s stimulus efforts kept consumers and companies from complete disaster, but they aren’t nearly enough to keep the economy expanding going forward.
Why the Stock Market Is Going Up
A few enormous and prosperous companies are behind the upward trend of the stock market.
It’s profits from listed firms that ultimately drive stock market returns, says Michael Edesess, adjunct associate professor at Hong Kong University of Science and Technology.
Recently, profits have been concentrated in a few tech companies that hold near-monopoly status, such as Amazon.com (ticker: AMZN) and the other “FAANG stocks.” These companies can keep wages low – many using gig workers – reducing demand and hurting economic growth, Edesess says. These lower-paid workers are also expendable when demand for goods and services slows.
Interest rates and federal monetary policy also impact the stock market.
The Federal Reserve sets monetary policy with the goal of controlling inflation, employment levels and maintaining stable economic growth. Current policies such as setting historically low interest rates and buying bonds are growing demand for publicly traded stocks.
The historically low interest rates encourage investment in the stock market, as fixed-income investing offers negligible returns.
The Fed model, which compares the earnings yield on the S&P 500 with that of the yield available on Treasury bonds, benefits stock market investing. The earnings yield is calculated by dividing the sum of the S&P 500 companies’ earnings for the previous year by the current index level. At present, the S&P 500 earnings yield is 4.5%, compared with the 10-year Treasury bond yield of 0.68% on Sept. 14. That’s a 3.82 percentage point spread in favor of stocks.
For investors seeking investment growth, there aren’t many alternatives to the stock market.
Many investors are concerned about the stock market’s high valuations when compared with historical levels. Looking at price-to-earnings, price-to-sales and price-to-book ratios, the stock market may appear overvalued.
Yet, in the near term, valuations are poor predictors of stock market performance, as stocks can trade at high valuations for long periods. In the shorter term, there are reasons for the stock market to be at the current levels.
Bottom Line: The Stock Market and the Economy
With today’s widespread uncertainty, investors and consumers are wondering what the future may hold – both for the stock market and the economy.
No one knows the future, of course, but we can use history to help understand potential outcomes.
Investment markets are considered forward-looking indicators, which means that investors buy and sell stocks based upon their expectations for the future.
“Currently, investors believe there will be a scientific solution to the virus, and until that happens, the Fed will continue to provide support for investors in terms of liquidity and low interest rates,” says Amy Bush, chief investment strategist at Tandem Wealth Advisors in Phoenix.
When you understand the inputs, it becomes clearer why the economy and the stock market are diverging. However, in the long run, the economy and the stock market tend to move in the same direction.
History also reminds us that the U.S. has recovered from many prior difficulties with both robust growth and a growing stock market.