February 26, 2021
Ever since the U.S. stock market rebounded from its March low last year, many people have pointed out the glaring disconnect between a pandemic-ravaged economy and stocks that continue to soar.
Spoiler… As wrong as it may seem, Main Street and Wall Street aren’t really correlated.
As recently stated on Bloomberg…
The market is not the economy. Its job is to tabulate investors’ consensus view about the future of publicly traded companies. It pays no attention to private businesses or government or other important parts of the economy.
The S&P 500 Index is up 72% since March 2020. Last year, America’s gross domestic product (“GDP”) shrank by around 3.5%, the most since World War II. And a net total of around 10 million Americans lost their jobs during the year.
Watching the news, you’d think the Great Disconnect was as contradictory as “government intelligence”… as impossible as a Sudoku crossword… as terrible a crime against humanity as ketchup on filet mignon… and as unjust – regular folks suffer as Wall Street fat cats loosen their belts yet another notch! – as a rainy day at the beach.
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It’s as if the market should know better, but still stubbornly refuses to bend to, you know, sanity and justice… and continues to hit new all-time highs, instead of crashing and burning like the economy.
“Investors baffled by soaring stocks in ‘monster’ depression,”
the Financial Times in April.
“The economy is in free fall. So why isn’t the stock market?”
asked Vox in May.
“The gap between markets and economic data has never been larger,”
moaned Citigroup in a research note in April.
“Why Doesn’t the Stock Market Care About All the Bad News?”
Money magazine demanded indignantly a few weeks ago.
And, on the surface, it does seem as weird and wrong as sandals with socks. To many people, it feels self-evident – the sky is blue, politicians lie – that higher economic growth should translate into higher stock market returns.
An (highly simplified) equation for it might go something like this:
Faster economic growth ⇒ More demand for companies’ services and products ⇒ growth in corporate earnings ⇒ share price appreciation.
And it follows that the converse (lower economic growth should result in lower share prices) would also be true.
In May, the Economist agreed… “Financial markets have got out of whack with the economy. Something has to give.”
And let’s not forget… that was all last year, when the S&P 500 was well below where it is now… global coronavirus deaths were a fraction of what they are now … and conventional wisdom was that by the autumn of 2020 – that is, nearly half a year ago – we’d be hugging and passing hotdogs down the row at ballgames and jostling each other in the subway like the old days. (And that was before America was on fire over the summer in the worst racial unrest in half a century… and before an armed mob took over the U.S. Capitol in the most serious assault on American democracy ever.)
The thing is, that dichotomy between the stock market and the economy is not unreasonable. It’s not wacky and ridiculous. And it shouldn’t be surprising at all.
However… The why – the real why – isn’t what you’d expect.
There are plenty of obvious explanations of why stocks are going up that are perfectly valid – but still miss the mark…
Earnings weren’t so bad last year. In a normal investment world, company earnings are an important driver of share prices. As a shareholder of a company – which is what you are when you buy a stock – you’re in essence “buying” a stream of future earnings of the company (including, sometimes, dividends). That stream is worth more if earnings are rising… and less if they’re falling. And according to Yardeni Research, the earnings of companies in the S&P 500 declined by 16% in 2020.
That’s a stiff drop from forecasts in February 2020, when Goldman Sachs issued a downbeat forecast of 0% growth (compared with a consensus of 7% earnings growth). And it’s also a decline from 2019, when overall earnings were up 0.6%.
If all that damage to the global economy, to supply chains, all those people out of work, all the victims of the coronavirus… if after all that 2020 had to offer, the stock market’s earnings fell only 16% – well, that’s actually not so bad, right?
But if all that damage to the global economy, to supply chains, all those people out of work, all the victims of the coronavirus… if after all that 2020 had to offer, the stock market’s earnings fell only 16% – well, that’s actually not so bad, right? Markets are about earnings – and also about expectations. And maybe 16% isn’t so awful considering, well, everything.
But that doesn’t answer the question – why didn’t earnings of listed companies fall more, if the economy has been so lousy?
Markets are forward looking. Stock markets are a leading economic indicator – that is, they telegraph the direction of the economy in advance. A downwardly trending stock market signals that the economy will soon be slowing. And a rising stock market suggests that the economy will be accelerating (which is what we’re seeing now). And earnings forecasts are an important ingredient of how markets look forward – because they suggest whether those all-important earnings streams are getting bigger or smaller.
Of course, earnings forecasts can be off… by a lot. Big companies are complicated beasts, and guessing next year’s earnings – even if you’re the CEO of a company, to say nothing of if you’re an outside analyst who’s juggling a few dozen companies in which he has no real insight – is like predicting next week’s weather by sticking your arm out of the window today. But it’s a start… and right now, earnings for the S&P 500 are forecast to rise 24% in 2021. That will take them above where they were in 2019. That’s a pretty good reason for markets to rise.
There’s a lot of money to be made out there chasing stocks. Ultimately, shares are like anything else (milk, yoga classes, or an autographed David Bowie vinyl) – their price moves up when there’s more demand (buyers) than supply (sellers). All the things that Investing 101 says matter about a stock – earnings, management, strategy, competitive position, balance sheet strength, and of course valuation – is trumped by supply and demand for shares. The share price of a company, whether it’s a shell that controls a pile of old dust, or the Superman-meets-Thor-meets-God of most excellent companies, is dictated solely by supply and demand.
Although a lot of that money is earmarked for various purposes… much of it is in the form of direct payments to individuals, and plenty of it leaks out at the edges.
And right now, there’s a lot of demand. The Federal Reserve has been pumping cash into the American economy at an unprecedented pace to soften the blow of the contraction in the economy. And although a lot of that money is earmarked for various purposes – from small business loan forgiveness to PPE for schools to fund for COVID testing – much of it is in the form of direct payments to individuals, and plenty of it leaks out at the edges. And all those Robinhood speculators with their stimulus cash burning a hole in their brokerage account are a source of enormous demand. When there’s liquidity, stocks rise.
Considering everything last year threw at us, 2020 earnings weren’t so bad… Markets are forward-looking, and what’s in the future for corporate earnings is actually pretty promising… And there’s a ton of money chasing stocks. These are all perfectly reasonable pieces of the puzzle for why share prices are rising.
But none of these explain the divergence between stock prices and the economy.
It turns out that economic growth being good for stock investors is a giant myth – like Bigfoot, an-apple-a-day-keeps-the-doctor-away, and doing-lots-of-crunches-will-give-you-abs-of-steel, combined – of the investment world.
As a 2004 paper by Jay Ritter of the University of Florida explains…
It is widely believed that economic growth is good for stockholders. However, the cross-country correlation of real stock returns and per capita GDP growth over 1900–2002 is negative.
Ritter analyzed GDP growth and stock market appreciation over more than a century in 16 countries that account for around 90% of total global market capitalization… and he waved a professorial math wand at it all. In other words, he found that higher economic growth is linked to lower stock market returns.
The point is that economic growth does result in a higher standard of living for consumers, but it does not necessarily translate into a higher present value of dividends per share for the owners of the existing capital stock. Thus, whether future economic growth is high or low in a given country has little to do with future equity returns in that country.
… Future economic growth is largely irrelevant for predicting future equity returns. This is because long-run equity returns depend on dividend yields and the growth of per share dividends.
In other words… stock market returns are all about earnings and what investors receive of those earnings. And that has nothing to do with economic growth.
A more recent paper, “Have Exchange-Listed Firms Become Less Important for the Economy?,” by the National Bureau of Economic Research, asks why we’re even talking about this at all…
There is no compelling theoretical reason for the stock market to be highly representative of the economy and there are many reasons for why it would not be. Firms that are listed are firms for which a listing is valuable. Not all firms find it valuable to be listed and these unlisted firms differ from listed firms. Further, market capitalization reflects the value of a firm for its shareholders, but this value need not be correlated with a firm’s contribution to employment or GDP.
The paper finds that the percentage of total employment at listed companies as a share of total non-farm employment in the U.S. has fallen from 41% in 1973 to 21% in 2019.
Think about this… In 1953, the U.S. company with the largest market capitalization – automaker General Motors (GM) – accounted for 1.39% of total U.S. non-farm employment. And in 2019, the biggest company by market cap, Apple (APPL), employed just 0.11% of all working Americans.
This is a perfect example of how what happens on Wall Street does not always translate to Main Street.
The head of GM at the time, Charles Wilson, said, “… for years I thought what was good for our country was good for General Motors, and vice versa” (often misquoted as “What’s good for General Motors is good for America”).
It’s difficult to imagine his present-day analogue – Microsoft CEO Satya Nadella, or Alphabet head Sundar Pichai – saying anything similar.
What’s good for the largest American companies today has, at best, an indirect relationship to what’s good for the economy. Stocks have been rising – despite the worst economic backdrop since the Great Depression – because the link between Wall Street and Main Street isn’t just tenuous… there’s no particular reason to think there even should be a connection at all. And in fact, that relationship has shown to work in exactly the opposite way than what you might think – stocks in fact tend to fall in a strong economy.
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Executive Editor, American Consequences
With Editorial Staff
February 26, 2021