Why the stock market is not the economy

The UK is in its deepest recession on record. The US economy, as measured by real GDP, contracted at a record-breaking 32.9% pace in the last quarter. The Bank of England has warned that one million UK jobs could be lost before Christmas. And, the Brexit cliff-edge approaches with the UK inching closer to a ‘no-deal’ scenario by the week.

These and dozens of economic measures suggest that, to put it euphemistically, the global economy could be better. And yet, earlier this month, President Donald Trump told reporters, “We have the strongest economy – performing economy – in the world.”

His comments come after the Dow Jones Industrial Average and S&P 500 have risen by more than 50% since bottoming out on March 23. The FTSE has also gained more than 1,000 points from its March low.

Why are stock markets performing well when it’s clear that economic meltdown is happening around us?

It’s because, to quote a well-used phrase, ‘the stock market is not the economy’. The divergence between stock markets and the wider economy has rarely been more pronounced. Here are some of the reasons why.

Big corporations better placed to withstand shocks than small businesses

The first thing to note is that the makeup of the stock market does not reflect the wider economy. The fact is that the giant companies that make up the FTSE 100 or S&P 500 operate under very different circumstances than small businesses.

These huge corporations are highly profitable, hold significant sums of cash and have regular access to public bond markets. In addition, they are far more global than the typical family business. For example:

• In a normal year, about 70% of the revenues generated by FTSE 100 companies come from overseas
• Roughly 40% to 50% per cent of the revenues of S&P 500 companies come from abroad.

In addition, because large, publicly traded firms operate nationally or internationally, they tend to be technologically capable and therefore well-positioned to compete in an environment of social distancing. Local businesses, in contrast, are more likely to be bricks-and-mortar affairs that are hampered by restrictions on movement.

In other words, the fact that local, small businesses have laid off thousands of workers – or that national firms in industries that have been devastated, such as airlines and hospitality – is relatively immaterial to the stock market.

As long as redundancies don’t lead to a ripple effect, where the broader economic troubles affect their revenues, their shares can quite logically rise even as other businesses fail.

It’s not ‘good’ or ‘bad’ – it’s ‘better’ or ‘worse’

It’s also worth considering here what stock markets care about. In simple terms, share prices aren’t really affected by whether the economy is ‘good’ or ‘bad’. If they were, they would be suffering right now.

Instead, prices are typically influenced by whether conditions are ‘better’ or ‘worse’.

So, with many experts predicting a swift recovery from the current situation, and that corporate profits will rebound fairly quickly, prices rise on the ‘better’ sentiment.

While there have been plenty of reasons to suggest that corporations won’t be as profitable in 2020, as predicted a few months ago, news about medical breakthroughs and vaccines suggest that things are getting ‘better’. It’s a positive development for the economy and for profits, and it pushes up share prices (and, therefore, the value of markets such as the FTSE 100).

Stocks and shares remain an attractive option – even in a recession

There’s one final point that’s pertinent here. Even in a recession, and even with a reasonable level of volatility, stock markets remain an attractive option for investors.

With UK interest rates at just 0.1%, and yields on bonds falling, markets continue to provide a good place for people to invest their money, rather than alternatives like bonds or banks.

Tara Sinclair, an economics professor at George Washington University, says: “People, particularly the rich, have cut back their spending, so they need to park their funds somewhere like the stock market (especially since interest rates are rock bottom).”

Considering the alternatives, shares remain attractive for many people – even in the middle of the deepest recession in history caused by a once-in-a-lifetime global event.

If you want to have a chat about your investment strategy, or you’d benefit from putting a financial plan in place, please give me a call on 07769 156 250.

 

Foster Denovo Limited is authorised and regulated by the Financial Conduct Authority.

The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.