Why Do the Markets Do Well When the Economy Isn’t?
The last few days notwithstanding, the stock market has staged a significant recovery from the market lows we saw in late March. While off its all-time high reached in February, the S&P 500 stands at a level that was first reached in the last quarter of 2019.
Yet the economy is suffering in the wake of the COVID-19 pandemic. Unemployment stands at levels not seen since the Great Depression. Many businesses have shut down or reduced operations. Retail, restaurants, the hospitality industry, airlines and many others have experienced vastly reduced revenues and earnings. The government has passed the CARES Act to aid both individuals and small businesses, but even that hasn’t been enough to completely stem the tide.
To answer the question raised in the title, we don’t know for sure. But we do have some thoughts.
Wall Street is not Main Street
What happens on Wall Street and in the financial markets is not always reflective of what is happening in the economy as a whole. A recent New York Times article covered this topic in depth. One quote from the article summed it up well, “Wall Street has very little to do with Main Street,” said Joachim Klement, a market analyst at Liberum Capital in London. “And less and less so.”
On the one hand, some might say that the stock market is forward looking and that this must mean that traders and Wall Street see better things ahead. That may well be true to some extent. But some of this divergence might also be tied to the increasing disconnect referenced by Mr. Klement in the Times article.
One difference is the fact that many of the companies driving the surge in the markets operate in a different environment than the local diner you enjoy eating at or many retail stores who rely on physical traffic.
As an example, if we look at the top five holdings in the SPDR S&P 500 ETF (ticker SPY), a large, heavily traded ETF that tracks the S&P 500, this will illustrate what we are talking about. Here are the returns for these holdings for the trailing one and three months as of June 24, 2020.
|Stock||1 mo. return||3 mo. return|
|Alphabet Class A (Google)||1.38%||26.79%|
These five holdings comprise about 20% of the index in terms of their market capitalization. All of these businesses are tech-based and not really reflective of many of the Main Street businesses that are struggling.
Stock market gains are not uniform
When we hear that the stock market is up, this usually means the Dow Jones Industrial Average or the S&P 500. Well, the S&P is made up of 500 companies and the Dow is only 30, but there are over 3,000 companies in total that comprise the U.S. stock market. Check out our recent vlog to learn more about the S&P 500 Index and the Dow Jones Industrial Average.
While the major averages, and many prominent stocks engaged in tech or other essential services (like grocery stores), have recovered nicely over the past couple of months, this recovery is not uniform across the entire stock market. Large cap stocks have, as a whole, fared better than small caps. Growth stocks, which include all five of the stocks listed in the table above, have generally outperformed value stocks.
Access to Capital
The Times article cited Ohio State professor René Stulz, who indicated that, as of 2015, only about 1% of the 600,000 U.S. companies employing 20 or more people were publicly traded. What this means is that many of these businesses may have more limited access to capital than larger, publicly traded companies.
While there are many large, well-capitalized private firms, being publicly traded does provide a business an additional avenue to raise capital by offering shares for sale to the public. Additionally, even when these companies are looking at other avenues to raise funds, such as through debt financing, their reputation and the relationships they have with commercial and investment banks may give them a leg up that smaller, private companies may lack.
Certainly, the local independent restaurant, hardware store or pharmacy may well have a banking relationship, but this relationship likely doesn’t extend to the level of capital that these and similar local businesses may need to stay afloat during periods like this one.
A Different Economy
The leading companies used to be large employers like utilities, automobile manufacturers and other labor-intensive companies. Today’s major companies tend to have large workforces, but the numbers pale in comparison. Tech companies and online retailers just don’t need the number of employees as would a large manufacturer. Add to this a tight economic situation for many retailers and old-line manufacturers, and it’s easy to see why unemployment is high even when the stock market is rallying.
As the economy continues to evolve towards an even greater emphasis on e-commerce, large companies will likely need even fewer employees, and the disconnect between the stock market and the main street economy will likely grow over time.
As you can see, Wall Street and Main Street seem to be less and less connected with each passing year, and this disconnect is one of the main reasons the stock market can be doing well when the economy as a whole is struggling.