The Stock Market is Up and the Economy is Down: What's Going On?
With the economy tanking, how come the stock market has gone up dramatically?
And continues to go up.
THE STOCK MARKET
Let’s decompose the stock market. When people talk about the stock market going up or down, they usually refer to an index such as the S&P 500 as the measurement. The S&P 500 is a market-value (cap, short for capitalization) weighted index. The ten most valuable companies account for over 20% of the total value of the index.
There are over 3,000 actively traded stocks. But the 500 companies account for over 80% of the total value of all stocks. They also account for a minuscule percent of the 10-20 million companies in the United States.
Public companies account for about one-fifth of U.S. employment. Small companies account for about half of private sector employment. Government accounts for about 10% of total employment.
So, the dominant public companies are not representative of the economy. They are not even a representative sample. They are publicly owned. Even the smallest is much larger than almost all other U.S. companies. They are usually multinationals. And the largest, most dominant companies in market value are technology companies. The six companies with the highest market value are Facebook, Apple, Amazon, and Alphabet (the parent company of Google. Counted twice. Don’t ask.), collectively known as the FANG companies, joined by Microsoft.
Technology companies account for over 30% of the total value of the S&P 500. Digital or online companies are 13 of the 20 most valuable corporations in America. Nine of them did not exist or were small companies 25 years ago.
THE VIRUS ECONOMY
The economy has gone into a depression, the worse since the Great Depression of the 1930s. Damage has been limited because of massive federal income maintenance programs for workers and small business owners.
The severe downturn, caused by the virus and attempts to control the spread of the virus, has made visible that the economy is divided into two parts. (Yes, I know this is a huge simplification but not as simple-minded as most economic theory.) There is the service sector, the largest employer. Most of the companies are small. Many of the employees are low wage. They work in buildings and meet customers. Services and their employees have been very hard hit by the virus and the depression. At the other end are the technology companies that dominate the digital economy. As a group, they have done well during the depression as consumers and business have used their digital platforms and services as substitutes for physical interaction (aka store shopping, visiting doctors’ offices, online entertainment and commuting to work).
This split is reflected in the stock market and the indexes. Of the 500 largest companies, 44, mostly tech companies, are up 20 percent or more since the market low of March 23. The big six are up over 60% since the bottom of the market, accounting for more than 40% of the increase in the value of the S&P 500. Tech companies like Nvidia and biotech companies account for much of the rest of the increase.
Less known is that approximately 160 companies of the 500 are down more than 20%. Although the market average is almost the same as at the beginning of the year, the stock prices of about 350 of the 500 companies are down. They are large and important parts of the older economy.
TIMING
The timing of the market moves is surprising. The market hit its high on February 19, a month before the president admitted there might be a problem and weeks before the more aggressive governors announced lockdown rules. While the president was telling the country there wasn’t a problem, investors began unloading stocks.
In the last week of March, as the president began hinting there might be a problem, the stock market hit bottom. As the number of new virus cases and deaths rapidly increased, and lockdown and quarantine rules were extended, the economy tanked. But the stock market began a rapid recovery, one of the strongest and quickest in history. Even as the virus situation worsened in most of the country, the stock market continued to go up.
During the strong advance no one, not even corporate management, had any firm idea what corporate sales and profits would be in the future. No one could do the usual financial analysis. Every wealth fund manager, financial analyst and investor I’ve talked to said the market was crazy, irrational, unpredictable (usually preceding by a colorful adjective).
But the main reason is obvious. The dominant companies in the stock market were part of the digital sector of the economy. Besides the monster tech companies, they were into telemedicine, video conferencing for fun, family and business, video streaming and other online entertainment, e-commerce, cybersecurity, and many other online services. Behind them was a large increase in cloud computing services.
The accelerated shift to these companies’ services and products indicated accelerated increases in sales and profits. The macroeconomic averages and totals for the economy looked dismal. But not for these companies.
The stock market looks ahead. Investors forecast. They anticipate. Today’s news and events have little influence, even short run influence, on stock price movements. Investors have placed bets on their best estimate (known among statisticians as SWAG – statistical wild-ass guesses) of what will happen to corporate sales and profits in the future. As my old econ prof used to say, “You puts down yer money and takes yer chances.” Transitory and political events, no matter how dramatic and urgent, usually have very short run or no influence on stock market prices.
But not the virus. By mid-March, it was obvious it would have a large and lasting impact on the economy. It was the powerful “exogenous shock” of economics (also known as the “black-swan” or “fat-tail” or “big tsunami” event).
The unknown was how big and especially how long. Politicians, especially the president and some Republican governors, argued the virus’ effect would be short-lived and not too deadly or disruptive. They dismissed the proposed attempts to limit economic activity to slow down the spread of the virus. The famous “V-shaped” recovery. It seemed that many investors agreed. As the market rose rapidly, new investors flocked to the market. Average daily volume so far this year is up over 60% compared to average daily volume in 2019. Much of the internet chatter sounded awfully familiar to me – it was the same as in histories of the 1929 stock market crash.
But the market hasn’t collapse (yet). The big difference is the massive income maintenance federal aid programs, along with the Fed’s massive money creation and its underwriting of virtually the entire debt market. Already about 40 million American workers (25% of the labor force) have received some form of federal aid. The main program has been unemployment benefits. The maximum benefit has been raised by $600/per week and eligibility standards have been loosened. About two-thirds of the workers who have been on unemployment received benefits as high or higher than their pre-virus income.
Investors are betting that worsening virus news will have little effect on the economic recovery, that federal income maintenance programs will go on as long as needed (or at least to the November elections), that the Fed will keep the Fed funds rate near zero and finance the massive government deficits, and that demand for online and digital services will continue to increase.
Result? Sometime in late 2020 or early 2021, total earnings would be expected to return to 2019 levels. The S&P 500’s price/earnings ratio (P/E ratio) of this forecast has already returned to the high 2019 levels.
New medical protocols are reducing the death rate. Sometime in the near future an effective vaccine will be announced. All of the stock market will go up. Given how crazy this market has been, I suggest waiting a week and then start cashing in some of your winnings.
THE STOCK MARKET IN 1933
Something similar happened in 1933. At the depths of the Great Depression, with the entire banking system near total collapse, the stock market started to recover. The main reason seems to have been that investors were encouraged by the optimism and vigorous pursuit of new laws and policies by the incoming president, Franklin Roosevelt. In that year, the stock market went up an amazing 66.7%.
SUMMARY
Investors, as investors, are not directly concerned about Covid-19. They are concerned about the economic consequences of the virus, both short term and long term, especially to public companies.
The dominant dynamic is that most of the economy’s industries and companies are experiencing accelerated movement to the digital economy. Face-to-face transactions are expensive. Check-out personnel and cashiers are disappearing in supermarkets, Target and McDonald’s. Retail stores will function more like local distribution warehouses. Think about classrooms and doctors' offices. And, in the future, a shrinking labor force will probably push up the low wage part of the labor market. Digital interaction will continue to be less expensive and more effective.
The stock market - don't look at the averages. Look at the winners and the losers. The stock market is up because it is dominated by digital and technology companies. Changes in relative stock prices indicate which economic sectors and companies will innovate and and grow their sales and profits faster than the overall economy.
One way to think about the stock market (big public companies) is that it is made up of past winners (past innovators), current innovators, and potentially successful (profitable and growing) future innovators. The market mostly invests in future growth based on innovation. It punishes "legacy" companies, in old industries with growth determined by the growth in total income, that stop innovating.
In short, investors are buying companies that are benefiting from the economic consequences of the virus and attempts to limit its spread. These same companies will continue to benefit after the virus is contained. Since these companies dominate the market and the averages, the market is going up. And, increasingly, these are the companies that will drive economic growth and will dominate the economy in the future.
For a discussion of some of the economic and governmental budgetary changes caused by the virus, see my After the Virus.
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