I usually don’t comment on market gyrations, because they’re mostly irrelevant to mindful investing. But since about March this year, everyone seems to be talking about how the crazy stock market is levitating despite the pandemic’s obvious impact on the economy. So, I couldn’t resist investigating why this is happening.
This graph from FiveThirtyEight shows that the most common economic indicators imply that the stock market should be tumbling.
But the stock market doesn’t seem to care, as shown in this year-to-date graph of the S&P 500.
In late March, the S&P 500 was down by more than 30%. But so far this year, the S&P 500 is up by 1.6%. And before September started, it was up by 10%! It just seems insane.
What are the possible explanations for why the stock market is ignoring the ongoing pandemic and dismal economy?
The Stock Market Is Not the Economy
The most common explanation for the apparent disconnect between the stock market and the economy is that the two aren’t as closely linked as you might assume. To start, consider that out of the 600,000 U.S. companies with more than 20 employees, only 3,600 are publically listed (or less than 1%).
So, it’s not terribly surprising that economic growth is negatively correlated with stock market growth in countries around the globe. In fact, data indicate that past investors would have netted better returns by investing in countries with lower per capita Gross Domestic Product (GDP) growth as opposed to countries with the highest growth rates!
Particularly in the U.S., history suggests there is a strong link between stocks and the economy. But the economy has changed a lot in the last half-century. For example, back in 1962, the two biggest U.S. companies (AT&T and General Motors) employed nearly 1.2 million people combined. But last year, the two largest companies in the S&P 500 (Microsoft and Apple) employed just 280,000 people. So, the link between big business and employment, one of the most common economic indicators, is much weaker than it used to be.
Although most of the economic indicators look pretty scary right now, none of them are necessarily direct predictors of short-term stock market moves. If they were, then investing would be as simple as timing the market based on leading economic indicators. But we know that routinely timing the market is impossible.
Short-Term Earnings Aren’t That Important
But what about earnings? They’re a direct measure of stock’s intrinsic value, and they’ve also crashed this year. Here’s a chart showing the quarterly percent change in S&P 500 earnings per share and price over the last six quarters.
Again, this seems crazy. As compared to the beginning of 2019, earnings plummeted by 70% in the first quarter of 2020. At the same time, the price of the S&P 500 declined by a mere 10% since the start of 2019 and was up 8% by the end of the last quarter.
But market fundamentalists point out that this apparent disconnect between earnings and prices simply shows that the most recent earnings (at least in isolation) are not that important to a stock’s long-term valuation. Consider that the median price/earnings ratio for the S&P 500 going back to the 1880s is about 15 and the median annual earnings growth is about 12%. If you do the math on these numbers, it means that investors are routinely willing to pay a price for a stock that’s equivalent to the next 8 years’ worth of earnings. So, from this highly rational perspective, half a year of bad earnings only represents about one-sixteenth of a stock’s present value.
The Stock Market Tries to Predict The Future
The math of price/earnings shows that stock investors are trying to predict a decade ahead, assuming they’re at least somewhat rational in aggregate. And the S&P 500 price action this year strongly suggests that investors are expecting the pandemic will only cause a quick dip in earnings, rather than a multi-year slump.
This assessment seems plausible given that we’ve already seen some rebound in earnings, which suggests that the pandemic hasn’t yet caused structural damage to the profit models of most large companies. And expert predictions that a vaccine will arrive by early 2021 imply that business could go back to normal pretty quickly. This view is reflected in most earnings predictions, per this example of S&P 500 estimated future earnings from YCharts.
Contrast this with the Great Financial Crisis of 2008. At that time, it felt to me like earnings were suffering more long-term damage because the entire financial system seemed to be grinding to a halt. Accordingly, that stock market decline lasted for about two years from mid-2007 to mid-2009, when stocks finally started to climb again.
However, the expectation of a quick-dip pandemic crash is merely one of many possible predictions, all of which are highly uncertain. Some famous investors have been yelling a quite different prediction that the market is indeed crazily optimistic and another crash is just around the corner. Recent stock declines starting in September could easily be the leading edge of the next stomach-turning fall. There’s no reason why the stock market can’t tank over and over again as pandemic and economic events continue to unfold.
The Pandemic Is Good For The Big Names
It became quickly obvious to me (and many others) that the initial lockdown response to the pandemic would actually be a huge boon to companies that cater to stay-at-home activities, like shopping on Amazon and watching movies on Netflix. As expected, the “FAANG” stocks (Facebook, Amazon, Apple, Netflix, and Google) were all up between 10% and 70%(!) by early August this year. Given that the five FAANGs represent more than 22% of the S&P 500 market cap, it makes sense that the index was up by as much as 10% in August this year.
In contrast, the 495 other companies in S&P 500 are down (collectively) by about 13 percent this year, according to Goldman Sachs. And this graph shows that broader market indices like the Russell 2000 (black line), which includes a wide variety of small-cap stocks, is down by about 10%, while the large-cap S&P 500 (blue line) is still above water.
It’s Bad for The Under-Represented
The businesses most obviously impacted by the pandemic response are restaurants, bars, and away-from-home entertainment including hotels and resorts. Using statistics mostly from the Visual Capitalist, I calculated that restaurants, bars, and non-home entertainment represent substantially less than 20% of the S&P 500 market cap¹.
And if we look outside the stock market, we find that 70% of restaurants and bars in the U.S. are single-unit small business operations that aren’t represented in the stock market at all. On the other hand, some big companies that serve restaurants and bars like Sysco (down 18% this year) are in the S&P 500 and have definitely felt the pain of the pandemic response.
Grab Bag of Other Explanations
Other popular claims for why the stock market is rationally ignoring the pandemic and economy include:
Don’t Fight The Fed (or Congress) – Although it’s too soon to find conclusive statistics, it seems likely that the CARES Act and Federal Reserve programs in 2020 have helped the stock market along with the overall economy. As compared to the 2008 relief efforts, so far this year the Fed has spent twice as much from a balance sheet perspective and the government has distributed three times the amount of federal stimulus.
And many observers are hoping for even more stimulus money to be approved by Congress soon, although that seems increasingly unlikely as each new day of political wrangling unfolds. The government spending spree has created huge amounts of cash sloshing around the financial system, and some of that cash has undoubtedly gone to the stock market.
The Wealthy Invest in Stocks – In terms of wealth, the top 1% of households own 39% of stocks, and the top 10% own 83% of stocks. And most rich folks aren’t immediately impacted by things like layoffs, and they have the means to cushion an array of economic blows. So, it seems reasonable that the relatively wealthy would continue to invest per normal and prop up the stock market.
And where else are they going to invest? Nominal bond and cash returns are likely to be around 1% or less for the foreseeable future, which means these investments will lose money in inflation-adjusted terms. Residential real estate seems to be holding up pretty well so far because of low interest rates. But with the new popularity of work-from-home, the future of commercial
Calm Algorithms – Some people claim that the ubiquity of computer trading has insulated the markets because “algorithms don’t panic”. But algorithms are also commonly suspected of exacerbating market crashes and are devised by programmers who may not be entirely rational. So, I don’t find this argument very compelling.
Conclusions
The market always seems to have a funny way of proving everyone wrong. When I first started to think about this post in early September, the stock market was at all-time highs. But in just the one month it took me to sit down and write this post, the S&P 500 declined by close to 10%!
We can always come up with explanations for why the stock market is acting “irrationally”. And it only takes a quick turn of fate to show that all those explanations had it exactly backward. Our explanations can be infinitely wrong, but the stock market is always “right”.
So, I sincerely wonder if everything I just wrote is absurdly misguided. Or maybe it’s more accurate to say that these explanations were reasonable for a while, but now, some new tide is turning and submerging them into irrelevance.
Perhaps the real reason I don’t like to write about market gyrations is that the vast majority of market explainers end up looking like fools, eventually.
1 – I excluded obvious in-home entertainment companies, like Netflix, to arrive at a value of just under 20%. But there are other in-home entertainment businesses that I likely missed. So, I concluded that, on balance, the heaviest hit businesses likely represent substantially less than 20% of the S&P 500.
