Stop Confusing The Stock Market With The Economy

Wall Street and Main Street often exist in two different realities.

Stock market performance has long been used as a barometer for the health of the overall economy. For example, the president regularly points to the Dow Jones Industrial Average performance as evidence that Americans are experiencing unprecedented levels of wealth.

The stock market crash that occurred in early March as a response to the coronavirus pandemic appears to be more of a correction now that stocks are back on the rise. So all must be well with the economy, right?

If you ask the nearly 40 million workers who have filed for unemployment benefits, or the third of Americans who were unable to pay their rent or mortgage last month, nothing could be further from the truth.

“Right now, it seems there are two rather stark American realities,” said Daniel Milan, managing partner of Cornerstone Financial Services. “In one, investors are experiencing a prosperous and promising outlook. The other one, felt by millions of American workers, is fraught with economic loss and vast uncertainty.”

By all the usual measures, stocks should be going down in value. The coronavirus pandemic still has many businesses shuttered, some of which have been forced to file for bankruptcy or go out of business completely. Unemployment rose sharply over the past two months, reaching nearly 20%, the highest it’s been since the Great Depression. And we likely haven’t experienced the full financial ripple effect of the shutdown.

Even so, stocks have essentially recovered from March lows, making the three-day bear market from March 23-26 the shortest one in history, Milan said. In fact, over the last two months, major U.S. stock indices have averaged a 34% return from the depths of the market downturn on March 23.

“Frankly, the market is in a confusing spot right now,” Milan said. So how can it be that the stock market appears in great shape while the U.S. economy is still sputtering?

Defining ‘The Economy’

“At the most basic level, the economy is the production and consumption of goods and services. It encompasses all individuals, companies and the government,” explained Lacey Cobb, a chartered financial analyst, certified financial planner and director of advice solutions at Personal Capital.

One of the most widely recognized measures of economic activity is gross domestic product, which represents the monetary value of all finished goods within a country during a specific time period. GDP essentially provides a snapshot of the economy’s size and growth rate. An ideal GDP growth rate is around 2%-3% per year. However, the Bureau of Economic Analysis estimates that U.S. GDP actually decreased by 5% in the first quarter of 2020.

Another indicator that’s probably most relevant to the average American is the monthly employment report from the Bureau of Labor Statistics. This shows the net total of jobs gained minus jobs lost.

According to the latest report, the number of unemployed Americans rose by 15.9 million to 23.1 million in April. That’s the sharpest month-over-month increase since the BLS started tracking this data in 1948. As a result, new unemployment claims are still highly elevated, though they are substantially down from the 6.9 million claims filed in the last full week of March. “Typically, new unemployment claims peak about two months before the economy hits bottom,” Milan said. “Should that hold true with the current April high, we should see the bottom in June.”

Daily federal tax receipts are also a good gauge of overall economic health, according to Milan, because they show the depth and breadth of our employment income situation. In the first quarter of 2020, before the COVID-19 crisis really took hold, receipts were up 19.7% compared to 2015, a range used for comparison because the date/month cycle is identical.

However, receipts in April 2020 were up just 2.6% versus 2015 data. In other words, “economic activity fell off a cliff,” Milan said. Even so, he noted that these economic indicators that lag equity markets are starting to show progress.

Why Is The Stock Market On The Rise?

The stock market is an exchange where the buying, selling and issuance of shares in publicly held companies takes place. Stock values are largely based on what is expected to happen in the future rather than what’s occurring right now.

“Tying the performance of the economy to the performance of the stock market assumes that what happens in the economy is accurately and promptly reflected in stock prices,” said Mark Carlton, a chartered financial analyst and portfolio manager at Trademark Financial Management. As you might have noticed, that’s not presently the case.

Because the market is forward-looking, it explains why stock values are on their way back up despite our weak economy. As cities begin to open back up and businesses resume operations, there is optimism that production and jobs will return to pre-crisis levels.

Indeed, industries that took a major dive after the coronavirus hit are crawling their way back. Hotel occupancy is back up as of May, as are gas purchases. On May 31, airport security checkpoints cleared 352,947 passengers, more than four times as many travelers as the lowest point on April 14. The number of prospective homebuyers contacting affiliated agents is now above pre-COVID-19 levels, while there were also two straight weekly increases in mortgage applications in May. Uber, which lost 80% of its business in the wake of the pandemic, stated rides were up for three consecutive weeks in early May and on track to continue increasing.

Why The Stock Market Isn’t Representative Of The Overall Economy

The fact that the stock market is a leading economic indicator isn’t the only reason there’s often a disconnect between it and the overall economy.

The market reflects the circumstances of the largest companies in the economy. The Dow Jones, for instance, is made up of just 30 major corporations. The five largest U.S. companies (all mega-growth technology companies) make up 20% of the S&P 500 Index and have been holding up much better than the majority of other companies during the pandemic.

“These firms may be experiencing conditions far different from much smaller companies,” Carlton said. “Access to credit, multiple business lines, product and labor adaptability are just some of the advantages that larger companies have.” And in the age of companies with $1 trillion market capitalization, such as Apple and Amazon, that may be truer than ever.

Small businesses ― independent companies with fewer than 500 employees ― are considered the lifeblood of the U.S. economy. In fact, small businesses account for two-thirds of net new jobs and generate 44% of U.S. economic activity, according to data from the Small Business Administration. Yet they don’t have the same representation in the stock market, Cobb said. “That means the U.S. stock market only represents a portion of U.S. employment and does not entirely reflect how economic gains are distributed throughout the economy.”

Measures taken by the government and Federal Reserve have also done a lot to bolster confidence for investors, but not necessarily for consumers. Particularly, the Fed’s decision to cut rates back down to 0% is good news for the stock market, as low interest rates boost the present value of future earnings. In theory, low rates can also help consumers by making it cheaper to borrow money, which frees up funds to spend and invest. But if people don’t have jobs (i.e., income), their money goes to putting food on the table and paying bills before buying homes and stocks.

The stock market is also often driven by narrative and not necessarily how the economy is doing objectively. “Narrative pulls investor dollars in or it scares [them] out, and the prevailing narrative can change in a hurry,” Carlton said. “We always attribute gains and losses to something concrete, like China or retail sales. But in truth, it is about the willingness of buyers and sellers at that time to accept a trade on the other’s terms.”

Not to mention, individual stocks are largely held by the most affluent investors ― the same people who are least likely to be impacted by an economic downturn. In fact, a staggering 84% of all stocks owned by Americans belong to the wealthiest 10% of households.

That’s not to say that the stock market and overall economy are completely unrelated. What’s important to understand is that day-to-day market swings don’t reflect what’s going on in the true economy. Over the long-run, the stock market and the economy do tend to have a stronger correlation, but that gap between Wall Street and Main Street isn’t getting any narrower.