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If you’ve been paying attention, you already know the incredible impact of the coronavirus pandemic on the U.S. economy. Recent data show 11 million jobs have been lost, small business closures and bankruptcies have spiked higher, and U.S. gross domestic product (GDP) has contracted sharply. Amazingly, while all of this has been happening, the U.S. stock market, as measured by the S&P 500 Index, was up for the year through late October. How is this possible? Shouldn’t stock prices reflect the conditions of the overall economy? How could the stock market be holding up so well when so many Americans are still struggling? The fact is, despite the tweets of President Trump that suggest otherwise, the stock market has never been a great barometer for how the economy is doing. There are a few reasons why this is the case.

The first reason why the two can seem disconnected is that participants in the stock market are focused on what they expect to happen in the future while economic data reflects what has already occurred. The COVID-19 crisis in 2020 has been a perfect example of this dichotomy. Stocks began to sell off in late February as soon as widespread lockdowns began to occur in anticipation of a slowdown in economic activity. Investors did not wait for the data to reveal an economic contraction was coming, they anticipated the worst and acted accordingly. Short-term economic indicators began to show the economic stresses due to COVID-19 in mid-March just as the market hit the low point of the cycle. Stocks have basically rallied since then even though the economic data worsened during the second quarter. They have rallied largely because unprecedented fiscal and monetary stimulus have led investors to believe the economy will improve even though some economic data have yet to show improvement. This phenomenon is not unusual and has occurred at the end of most bear markets throughout history. During the 2008–2009 financial crisis, for example, the S&P 500 Index hit a low in March of 2009 but the unemployment rate continued to increase until it peaked in October of the same year. Economic growth was also still negative in March of 2009 but turned positive later that year.

Another reason why stocks can perform differently than the economy is that stock prices are mostly driven by corporate profits and whether investors expect profits to grow. More specifically, the stock market is a barometer for expected profit growth for large publicly traded companies, which are only a small subset of total economic activity. A report published by the U.S. Small Business Administration shows that 44% of U.S. economic activity is driven by small businesses,1 most of which are not publicly traded. It is also important to note that some corporate behavior can have a positive influence on corporate profits but a potentially detrimental impact on the economy. A good example of this is corporate layoffs that might improve a company’s profitability but also increase the unemployment rate. Stock buybacks are another example of a situation in which the buyback may improve profits per share and probably the stock price, but it may not be the best use of capital to improve overall economic growth in the future.

The characteristics of the stock market are also not representative of our economy. The performance of the stock market is mostly determined by the performance of the largest companies that don’t necessarily reflect the economic profile of the country. The five largest publicly traded companies right now represent about 20% of the entire U.S. stock market and they are all technology-related companies that have unusually high earnings growth. Various stock indexes define small companies differently, but in general, smaller companies make up only about 10%–15% of the U.S. stock market and most of these companies are significantly larger than the average small business in the United States. As mentioned earlier, small business represents a large portion of overall economic activity in the U.S. and the composition of those small businesses is significantly different than the major stock indexes. Approximately 34% of small businesses in the U.S. are in the construction, restaurant, or retail industries.2 By contrast, these industries account for just 9% of the U.S. stock market.3

Despite the prior points, it is important to note that the stock market and the economy are not totally disconnected, and, in the long run, the stock market should reflect economic reality. An excellent analogy is that of a person walking a hyperactive dog on a leash. The person is (usually) walking calmly with a direction in mind, while the dog is running all over the place seeking the latest object of its attention. Other people in the park notice the obnoxious dog but pay very little attention to the person on the other end of the leash. The dog, at times, may travel in a totally different direction than the dog walker but they will both ultimately be headed in the same general direction. In this analogy (if you haven’t figured it out already), the dog is the stock market and the dog walker is the economy. The stock market gets all the attention and can move in unexpected ways based on the latest object of investors’ attention, but the stock market is still ultimately tethered to economic reality.

Investors can get into trouble if they spend too much time watching the “dog” and trying to anticipate where it will go next. Although it is sometimes difficult to remain patient when stocks are falling (or when walking a hyperactive dog), investors need to focus on the long term and have confidence that economic growth is likely over longer time frames and that the stock market will ultimately reflect that growth over time.

Footnotes:

1 K. Kobe & R. Schwinn, Small Business GDP 1998–2014, U.S. Small Business Administration, 2018

2 Small Business Trends Alliance, Small Business Trends 2020, 2020

3 Sum of the Retailing industry and Homebuilding and Restaurant subindustries using the Global Industry Classification Standard (GICS®) for the Russell 3000 Index.

Filed under: Investing

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