Why a buoyant stockmarket now makes sense

The global economy is not healthy. The economic collapse in Australia and the US is the worst since the Great Depression. In the US, COVID-19 has caused over 160,000 deaths and the unemployment rate is above 10%. Despite this, many stockmarkets appear quite buoyant. The Nasdaq 100 Index in the US is up 30% since the beginning of 2020.

How can this be? Are the markets being rational? Is there a disconnect?

Whilst financial markets are highly efficient information processing machines, we know they don’t always get it right. But a buoyant stockmarket and stalled economy are not necessarily in contradiction. There are many sound reasons why the economy and stockmarkets don’t march in step.

Forward Looking

Stock prices are supposed to reflect market expectations of the future profits of companies. When COVID first took hold, the Australian stockmarket fell by 37% in five weeks – the fastest fall on record. This was the market reacting to both the certainty that company profits would fall, but also the uncertainty as to how much they would fall and for how long. No one had lived through a global pandemic before.

In recent times, there has been good news about medical research developments to make the market believe companies will be more profitable in future years than we might have expected in recent months. Investors have increasing reason to believe we will see widespread distribution of one or more vaccines by mid-2021, with 167 vaccines currently in development and the Oxford University vaccine appearing the most promising candidate. That’s a positive development for the long-term outlook for the economy and for corporate profits, and so it should push stocks up, or at least offset the downward push from the bad nearer-term news. But you wouldn’t expect good news about the future to show up in current job creation or consumer-spending data.

Whilst the stockmarket has bounced around 30% from March 2020 lows, it remains 20% below the highs reached in February 2020.

The stockmarket – both in Australia and the US – focuses on very large companies with global footprints. Often the economy people experience, whilst bleak at present, is local and personal and is either not publicly traded or plays only a small role on stockmarket moves. Market capitalisation helps explain why the stockmarket can still rise when some sectors of the economy are in decline.

Market Capitalisation

Looking at the US, let’s focus on some of the worst-performing industries from January to July 2020:

department stores, down 63%;
airlines, down 55%;
travel services, down 51%;
oil and gas equipment and services, down 51%;
resorts and casinos, down 45%; and
hotel and motel real estate investment trusts, down 42%.

These are highly visible industries, with companies that are well-covered by the news media with household names known to many consumers. Retailers are everywhere we go. So although high visibility industries may be of considerable significance to the economy, they are not very significant to the capitalisation-weighted stock market indexes.

Consider how little these beaten-up sectors above affect the indexes. Department stores may have fallen 62%, 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.

The market is telling us that these industries just don't matter very much to stockmarket performance. And the sectors that do matter? Consider just four industry groups - internet content, software infrastructure, consumer electronics and internet retailers - account for more than $US8 trillion (A$11.2 trillion) in market value, or almost a quarter of total US stockmarket value of about $US35 trillion. Take the 10 biggest technology companies in the S&P 500 and weight them equally, and they would be up more than 37% for the year. Do the same for the next 490 names in the index, and they are down about 8%. That shows just how much a few giants matter to the index.

In Australia, one internet retailer, JB Hifi, projects their 2020 profit will rise by 20%+.

On some level, it's completely understandable why many people believe that markets are no longer tethered to reality because the performance doesn't correspond to their personal experience, which is one of job loss, economic hardship and health concerns for family and friends. But what's important to understand is that indexes based on market-cap weighting can be - as they are now - driven by the gains of just a handful of companies. And Stewart Partners investment approach is founded on a market capitalisation approach, for reasons discussed here: the-perils-of-owning-individual-stocks-more-losers-than-winners

Academic Evidence

Academics have also produced information to demonstrate stockmarkets are indeed forward looking.

Below we have two graphs. Panel A plots US gross domestic product (GDP), or the total value of goods and services produced by the economy, against the equity premium (or stockmarket return minus one-month US Treasury bills, known as the risk free asset) in the same year. Panel A shows no discernible relationship between the two, which indicates a change in GDP has not resulted in a simultaneous change in stockmarket returns.

In Panel B, we plot GDP growth against the previous year’s equity premium, and suddenly a noticeable relationship becomes visible. The positive trend in the data suggests market prices have reacted to changes in GDP, but have done so in advance of these economic developments coming to fruition. This result is consistent with markets pricing in their expectation of economic growth.

Government Debt

It is prudent to also consider the eventual fallout from increasingly large government expenditures designed to ease the economic burden of the COVID-19 pandemic. Will these efforts ultimately create a financial burden that affects future stock returns?

The table below should help allay concerns over government debt levels impacting equity market performance. When we sort countries each year on their debt-to-GDP for the prior year (top panel), average annual equity premiums have been slightly higher for high-debt countries than low-debt countries in both developed and emerging markets. However, the return differences’ small t-statistics—a measure of the precision of a value’s estimate – suggest these averages are not reliably different from one another.

Investors may be more focused on where they expect the debt to end up, rather than on where it’s been. In the bottom panel, countries are ranked on debt-to-GDP at the end of the current year, assuming perfect foresight of end-of-year debt levels. Again, average equity premiums have been similar for high- and low-debt countries. Like the results for GDP growth, these results imply that markets have generally priced in expectations for future government debt.

Summary – Markets at Work

For the reasons detailed above, it’s hard to conclude stocks are in a bubble, or investors have failed to grasp how bad things are right now.

We can argue about whether the way the market reacts is good or bad and never reach a satisfying conclusion. But one thing the market isn't is irrational or disconnected from the reality of market capitalisation, and its impact on stock indexes.

Macroeconomic variables and investment decisions are like frozen turkeys and deep fryers—caution should be exercised when combining the two. The results presented here are consistent with markets aggregating and processing vast sets of macroeconomic indicators and expectations for those indicators. By incorporating this information into market prices, we believe public capital markets effectively become the best available leading macroeconomic indicator.

Author: Rick Walker

References:

Under the Macroscope: When Stocks and the Economy Diverge – Dimensional Fund Advisors, 22 May 2020
Why markets don't seem to care if the economy stinks, by Barry Ritholtz, 7 August 2020
The Economy Looks Rough. The Stock Market Doesn’t. Here’s Why That May Make Sense, by Josh Barro, New York magazine, 23 July 2020