The disconnect between the stock market and the economy
Author: Daniël Asselbergs
October 23, 2020
The SARS-CoV-2 virus caused the stock market to plummet in March. We have since March seen a major recovery in asset values. The major stock indices, such as the Dow Jones and the S&P 500, have actually posted a positive YTD return. Moreover, the Nasdaq 100 has seen a great YTD return, one that is over 25 percent. This happened while the estimated annualized GDP declined sharply, with some countries experiencing a drop of around 10 percent according to the IMF. With an ever increasing amount of virus cases and an increase in the amount of lockdowns, one would wonder why the stock indices post all-time highs. All of this with the absence of a working vaccine and uncertainty about when the pharmaceutical industry will produce a working one. This article will discuss some of the factors that contribute to the sharp increase in asset prices.
Fiscal stimuli have been one of the main economic factors that bolstered the stock market. Major countries, such as the United States, produced fiscal stimuli policies that were implemented immediately. The United States saw an unprecedented large amount of fiscal stimulus, totalling 2.3 trillion dollars. The democrats and republicans are currently discussing the next stimulus package. However, it is expected that there will not be an agreement regarding the amount and rules surrounding the stimulus until after the election of the new president. The Federal Reserve announced that they will be buying up obligations from the US companies, which gave the retail and institutional investors a lot of confidence in the US stock market. A reason that increasing the amount of government debt was possible is because the interest rates were dramatically lowered, thus making interest payments on debt much smaller. This change in the interest rate is also the next point of discussion.
It is common in times of low economic activity that governments decrease interest rates so that borrowing becomes more attractive. Those cheap loans increase the amount of money that is spent on services and goods. This is only part of the reason why this is good for the stock market. The other reason would be that stock market valuations are calculated based on a few models, one that especially is influenced by interest rates is the discounted cash flow model. This model calculates the worth of a company based on the future cash flows it is predicted to produce. Those future cash flows are then transformed into the current valuation of those future cash flows. The calculation uses a discount rate that is largely set by interest rates. When the interest rate decreases, the current value of future cash flows increases, making all companies more valuable.
Another factor involved is that the major stock indices are largely impacted by the largest companies within the indice. The S&P 500 is weighted based on the market capitalization, resulting in the fact that larger companies also have more influence on the indice. The five largest holdings of the S&P 500 are Microsoft, Apple, Amazon, Alphabet and Facebook. These five companies account for around 20% of the total indice. The index however holds 500 companies, which means that one percent of the companies that make up the S&P500 influence one fifth of the change in the price of the index. These five companies have seen exponential growth in their valuations since these firms actually performed quite well or even better during this pandemic. For example, Amazon has benefited from the increase in online sales. Microsoft made more profit due to the influx of more Microsoft Teams users and an increase in the use of the cloud. The higher valuations for these companies also boosted the increase in the price of the indices.
The last reason why the stock market is trading at these valuations is because trading platforms, such as TD Ameritrade, Charles Schwab, Robinhood and DeGiro, have seen a dramatic increase in the amount of users. To illustrate, DeGiro had a waiting list of more than 50.000 potential users. This increase in new retail traders also caused an inflow of capital in the stock market, and an increase in the demand for stocks, with the same supply of stocks, caused prices to rise.
In conclusion, it has been established that the stock market is future oriented and that valuations are based on future performance. With this in mind, in addition to the points discussed above, results in the conclusion that the stock market is not overpriced. This especially becomes apparent when you investigate individual companies within a sector that has been hit the hardest by the pandemic. Commercial air travel companies are still trading near their 52 week low. The indices however do not reflect this because they are most influenced by the largest companies of the world.
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