Note: An earlier version of this article was first published in MoneyOwl’s website. MoneyOwl is Singapore’s first bionic financial advisor and is a joint-venture between NTUC Enterprise and Providend (Singapore’s first fee-only financial advisor). This article is a collaboration between The Good Investors and MoneyOwl and is not a sponsored post.
The apparent disconnect between the stock market and the economy is one of the hottest topics of discussion in the finance community this year.
Let’s look at the USA, for example, since it’s home to the world’s largest economy and stock market (in terms of market capitalisation). Due to the ongoing restrictions on human movement to fight COVID-19, the country’s economy inched up by just 0.6% in the first quarter of 2020 compared to a year ago. The second quarter of the year saw the US’s economic output fall by a stunning 9.0%; that’s an even steeper decline compared to the worst quarter of the 2007-09 Great Financial Crisis. Yet the US stock market – measured by the S&P 500 – is up by 4.1% in price as of 30 September 2020 since the start of the year.
Many are saying that this makes no sense, that stocks shouldn’t be holding up if the economy’s being crushed. But here’s the thing: The stock market and the economy are not the same things, and this has been the case for a long time.
A walk down memory lane
Let’s go back 113 years ago to the Panic of 1907. It’s not widely remembered today but the crisis, which flared up in October 1907, was a period of severe economic distress for the USA. In fact, it was a key reason behind the US government’s decision to set up the Federal Reserve, the country’s central bank, in 1913.
Here are excerpts from an academic report published in December 1908 that highlighted the horrible state of the US economy during the Panic of 1907:
“The truth regarding the industrial history of 1908 is that reaction in trade, consumption, and production, after the panic of 1907, was so extraordinarily violent that violent recovery was possible without in any way restoring the actual status quo.
At the opening of the year, business in many lines of industry was barely 28 per cent of the volume of the year before: by mid- summer it was still only 50 per cent of 1907; yet this was astonishingly rapid increase over the January record. Output of the country’s iron furnaces on January 1 was only 45 per cent of January, 1907: on November 1 it was 74 per cent of the year before; yet on September 30 the unfilled orders on hand, reported by the great United States Steel Corporation, were only 43 per cent of what were reported at that date in the “boom year” 1906.”
You can see that there were improvements in the economic conditions in the USA as 1908 progressed. But the country’s economic output toward the end of the year was still significantly lower than in 1907.
Now let’s look at the US stock market in that same period. Using data published by Nobel-Prize-winning economist Robert Shiller, I constructed the chart below showing the S&P 500’s performance from 1907 to 1917.
It turns out that the US stock market fell for most of 1907. It bottomed out in November of the year after a 32% decline from January. It then started climbing rapidly in December 1907 and throughout 1908, even though 1908 was an abject year for the US economy. And for the next eight years, US stocks never looked back. What was going on in the US economy back then in 1908 was not the same as what happened to its stocks.
There’s no link
It may surprise you, but studies on the long-term histories of stock markets and economies around the world show that there’s essentially no relationship between economic growth and stock prices over the long run. One of my favourite examples comes from asset manager AllianceBernstein and is shown below:
Despite stunning 15% annual GDP growth in China from 1992 to 2013, Chinese stocks fell by 2% per year in the same period. Mexico on the other hand, saw its stock market gain 18% annually, despite anaemic annual economic growth of just 2%. A wide gap can exist between the performance of a country’s economy and its stocks for two reasons.
First, stocks are ultimately driven by per-share earnings growth as well as changes in valuations (how much investors are willing to pay for each dollar of earnings). On the other hand, a country’s economic growth is driven by the revenue growth of all its companies. There can be many obstacles between a company’s revenue growth and earnings growth. Some examples include poor cost-management, dilution (where a company issues more shares and lowers its per-share growth), and regulatory pressures (such as a company facing an increase in taxes). Second, the presence of revenue growth for all companies in aggregate does not mean that any collection of companies are growing.
What this means is that if we’re investing in stocks, it’s crucial that we focus on companies and valuations instead of the economy. This brings us to the situation today.
Underneath the hood
We have to remember that when we talk about the stock market, we are usually referring to a stock market index, which reflects the aggregate stock price movements for a group of companies. For example, the most prominent index in the USA is the S&P 500, which consists of 500 of the largest companies in the country’s stock market. There are two things worth noting about the index:
- The American economy has more than 6 million companies, so the S&P 500 – as large as it is with 500 companies – is still not at all representative of the broader picture.
- The S&P 500’s constituents are weighted according to their market cap, meaning that the companies with the largest market caps have the heaviest influence on the movement of the index.
According to the Wall Street Journal, the S&P 500’s five largest companies in the middle of January 2020 – Apple, Microsoft, Alphabet, Amazon, and Facebook – accounted for 19% of the index then. Here’s how the five companies’ businesses performed in the first half of 2020:
Although the US economy did poorly in the first half of this year, the S&P 500’s five largest companies in mid-January 2020 saw their businesses grow relatively healthily. What’s happening in the broader economy is not the same as what’s happening at the individual company level, especially with the S&P 500’s largest constituents. From this perspective, the S&P 500’s year-to-date movement (the gain of 4.1%), even with the gloomy economy as a backdrop, makes some sense.
In fact, the recent movement of stocks makes even more sense if we dig deeper. On 4 August 2020, Bloomberg published an article by investor Barry Ritholtz titled Why Markets Don’t Seem to Care If the Economy Stinks. Here are some relevant excerpts from Ritholtz’s piece:
“Start with some of 2020’s worst-performing industries: Year-to-date (as of the end of July), these include department stores, down 62.6%; airlines, off 55%; travel services, down 51.4%; oil and gas equipment and services, down 50.5%; resorts and casinos, down 45.4%; and hotel and motel real estate investment trusts, off 41.9%. The next 15 industry sectors in the index are down between 30.5% and 41.7%. And that’s four months after the market rebounded from the lows of late March…
…Consider how little these beaten-up sectors mentioned above affect the indexes. Department stores may have fallen 62.3%, but on a market-cap basis they are a mere 0.01% of the S&P 500. Airlines are larger, but not much: They weigh in at 0.18% of the index. The story is the same for travel services, hotel and motel REITs, and resorts and casinos.”
It turns out that the companies whose businesses have crashed because of COVID-19 have indeed seen their stock prices get walloped. But crucially, they don’t have much say on the movement of the S&P 500.
Conclusion
Stock market indices are useful for us to have a broad overview of how stocks are faring. But they don’t paint the full picture. They can also move in completely different directions from economies, simply because they reflect business growth and not economic growth. The main takeaway is that when you’re investing in stocks, don’t let the noise about the economy affect you from staying invested as they don’t always move in the same direction. If you invest in stocks, look at companies and not the economy.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have a vested interest in the shares of Alphabet, Amazon, Apple, Facebook, and Microsoft. Holdings are subject to change at any time.