The Disconnect Between The Stock Market and the Current Economy

The Disconnect Between The Stock Market And The Current Economy

The COVID19 crisis has left millions jobless and generated the largest quarterly GDP decline after the Great Depression. This crisis has led to profound skepticism about the current slowdown’s ultimate length and depth and the final recovery’s shape. Despite the slowdown in the economy, the global stock markets have risen and show no slowdown. This article provides insights into the disconnect between the stock market and the current economy.

Business uncertainty invariably leads to stock market volatility. However, there is likewise a standard pattern across most recessions. First, the equity market declines harshly as negative news spreads, expedited by some investors’ panic selling and unintentional triggers in the algorithmic trading. Typically, the overall effect is an overreaction that savvy investors abuse by purchasing shares, which in turn drives to a complete or partial rebound long before the economy has completely recovered. In the current situation, both the slump and the rebound took place very soon. The S&P 500 index sank by more than 30% near the end of March. Then, by mid-June, it had bounced back to within about 5% of its value at the start of the year.

The five most significant companies: Apple, Amazon, Microsoft, Google, and Facebook, constitute about 23% of the S&P index, the highest concentration in at least 30 years. Apple contributes more than half of the S&P index’s 4.8% total return this year. Investors speculate that the impact will rise as employees continue working from home and shopping and streaming movies online. Amazon shares surged 68% in 2020, Microsoft 30%, Facebook likewise 30%, and Alphabet 13%.

Main Factors — The Disconnect Between The Stock Market And The Current Economy

Two factors can comprehensively describe the disconnect between the misery of unemployment and a major recession on the one hand and the comparative resilience of the stock market on the other.

1. First, the market values the long-term profits and cash flows of companies, not just this year’s but also it’s near future. Thus, we see why even such desperate times as we are undergoing today do not significantly affect companies’ aggregate value. No one understands the width and length of this financial recession, though let’s consider that corporate profits will be 50% lower than they otherwise would have been for the next two years and then revert to levels that are 5% below than otherwise. When we discount the result of these lower profits and cash flows, it implies a reduction in the stock market’s present value of less than 10%.
2. The second reason is that the global stock exchange structure has evolved considerably over the past 25 years. It is now densely weighted to businesses in technology, media, telecommunications, pharmaceuticals, and medical devices. These fast-growth industries have grown their share of the index to 40%, while slow-growth industries (Eg: industrial and consumer products) have dwindled from around 35% to 20%. The virus surge has accelerated digital technologies’ adoption to make enterprise software and other information-processing technology growing exponentially. The famous “stay-at-home” stocks like Peloton, Shopify, and Netflix have all easily exceeded broader markets. FAANG (Apple, Microsoft, Amazon, Alphabet, and Facebook stocks) have added $765 billion in market capitalization. Conversely, oil and gas and travel-related companies are slipping by 20% or more, but because of the change in the weightings, these slumps don’t have approximately the influence on the market index that they would have had 20 years ago.

The Curious Case Of Tesla

In various ways, Tesla summarizes today’s market, in which retail and institutional investors have pursued companies promising high growth. The OEM has become synonymous with hoarding into stocks that have risen the fastest and furthest. Few equities can rival the speed with which Tesla has risen.

Data from Société Générale SA confirm that retail investors tend to favor stocks that have grown the most over the preceding three months. Investors have too piled into exchange-traded funds tracking the momentum trade. And like the larger market, Tesla has been painstakingly challenging to bet. Some saw its dramatic rise, and the rise continues to scare and burn many investors seeking to profit from its demise. Technical dynamics better illustrate the stock’s mind-boggling gains since bearish wagers on the company have inadvertently fueled Tesla’s rise, and derivatives bets tied to its advance have supported increasing the rally.

Many investors aren’t merely acquiring small dips in the stock market or specific shares like Tesla. They are looking for turbocharged trades that profit when individual stocks instantly rise and, at times, pledging money to gamble big.

Other Factors — The Disconnect Between The Stock Market And The Current Economy

There are several other factors at play in the stock market response. Some general employment sectors, such as department stores, were previously languishing before the pandemic hit. Their market capitalizations were flat at the start of the crisis, so further slumps didn’t move the index. Additionally, many high-employment sectors — including restaurants and local services — are controlled by privately-owned companies whose pain doesn’t change the stock index. Investors and analysts often appear to ignore these fundamentals in valuing businesses, concentrating too much on earnings multiples such as P/E or EV/EBITDA ratios. When you think that multiples drive business valuation, it is intriguing to believe that a 50% earnings reduction will point to a similar drop in value. That would exist if the earnings multiple were to stay consistent. However, when earnings swiftly decline, the earnings multiple will have to move up if there is an expectation that the company will redeem wholly or partially.

Final Thoughts

It may be counterintuitive: in times of crisis, many would not anticipate multiples to expand. However, that is what the fundamentals would predict. And if we see at the global stock markets during the contemporary crisis, this’s what has happened: the short-term earnings outlook was bearish, but the price-earnings multiple is bullish. Thus, the decline in value for the global stock market has not been nearly as substantial as the slump in the short-term earnings outlook.