Have Markets Lost Touch with Reality?

An explosive recovery from the bear market lows of March has many wondering if equity investors may be out of touch with what is really happening in the broader economy. How can it be that stock markets are surging toward record highs despite COVID-19 anxiety, double digit unemployment, weak corporate profits, and a U.S. political landscape that remains very much unsettled?

It does seem logical to presume stock market performance and economic conditions should go hand in hand. After all, economic growth should result in higher corporate profits which in turn boost earnings to support higher share prices.

Despite this sound reasoning, history has shown a low, and sometimes even negative, correlation between stock market returns and measures of overall growth in the economy (GDP). Let me share our thoughts on why this happens and how we view the current disconnect between equity markets and the economy.

Look under the Hood

Despite Donald Trump’s assertions that everything is fine when the stock market goes up, the stock market is not the economy. In fact, stock markets are often represented by indexes (think S&P 500), which are comprised of a very select group of firms that are publicly traded. Most indexes are market cap weighted so larger firms have more impact on the overall magnitude of index movements. Just looking at index performance data can be misleading since that data is influenced by an increasingly small group of large companies.

From the chart above, note how influential large stocks can be on the whole index. Year to date, the S&P 500 has a positive return but only because of strong returns from a few large companies in the index. The ‘other 495 stocks’ have not fared nearly as well as the index would imply. A few companies have benefitted from the fallout of the COVID-19 pandemic, but most have not.

Full Steam Ahead

Stock markets are forward-looking, and they attempt to reflect the future economy rather than the present one. Equity markets have rallied recently in large part due to the massive injections of liquidity by central banks, large government support programs, and a realization that pandemics are temporary rather than permanent. All that ‘new’ money must go somewhere and much of it has found a home in stocks, specifically larger cap tech stocks. It is also worth noting the laser-like focus on vaccine development and new drug therapies to deal with COVID-19 are also being priced into markets by investors.

The so-called disconnect between the economy and stock markets is not that unusual given the forward-looking nature of the markets. What may be unusual is the magnitude and speed of the recovery of the stock market, but with all the stimulus being applied it should not be all that surprising in retrospect.

Many people point to profit margins and/or earnings growth (declines) as the major disconnect but it was expected that margins would decline. It is the bottoming and future direction of margins that is key. Profit margins will rise from these depressed levels. The big question is “have valuations fully discounted the rise” or, stated another way, “have P/E multiples bounced too far, too fast?”

In the past, P/E ratios often exploded higher in anticipation of an earnings recovery. Given the magnitude and speed of the rise, especially in the past few months, we are exercising caution and are not adding to equities aggressively – we may be reducing exposure in certain areas.

What Is on the Other Side?

We believe that eventually the economy will catch up to the stock market. In the meantime, investor sentiment is being supported by massive monetary and fiscal backstops. While we do see signs of momentum building in the global economy, we do expect lingering impacts from the deep recession that followed the COVID-19 crisis.

Political uncertainty is also a growing factor as the U.S. presidential election nears. This event has the potential to become an increasing drag on business confidence and corporate planning over the next couple of quarters.

We expect the economic rebound for some sectors (e.g., travel and hospitality) to be muted with risks to recovery tilted to the downside, in part due to the threat of second-wave infections.

As a result, we have a relatively cautious view on near-term economic growth. We maintain a constructive view of equities longer term, but we have moderated the level of our conviction given the extent of gains since the March lows.

Comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.