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Booming Stocks vs. Struggling Economy: Understanding the Difference

If you’ve followed the economic data in 2020, you’d know that we just experienced the deepest recession since the Great Depression. If you’ve followed the stock market data, you’d know that stocks are now up 15% this year, nearly twice their historical average. 

The global pandemic has thrown many curve balls at us this year, and the gap between the economy’s performance and the stock market’s performance is one of the bigger ones. Stocks are back on the rise while many individuals - and the country as a whole - are still facing the effects of business closures, record-breaking unemployment rates and more. How can this be? 

Below, we outline the major differences between the stock market and the economy and why one can progress while the other tells a different story.

The Economy – Aren’t We In A Recession?

One way we can understand the economy is through real GDP (gross domestic product), which measures the value of goods and services while factoring inflation into the equation. As demand changes more quickly than supply, we typically see economic cycles, or periods of over- and undersupply.  Other factors within these cycles include the responses from the consumer (think fear and greed) and from policymakers (the Federal Reserve Bank and Congress.)

Economic Health Pre-Pandemic 

While we clearly entered a recession in March of this year, we did so in a rather unusual way. Unlike past recessions, which are typically preceded by oversupply (e.g., 2007 housing bubble), tightening money supply (e.g., 1982 & Paul Volcker), and exuberant optimism (e.g., 1999 tech bubble), we didn’t have many excesses built up in our economy. We simply shut down to fight a rising virus.

The Stock Market – Are We In A Bubble? 

The forces of supply and demand are evident in the stock market, although the speed with which they move is much faster than in the economy. Importantly, a look at historical stock prices shows how stocks are forward looking, i.e., their prices move in anticipation of what the future may hold.  Indeed, the S&P 500 Index is a “leading indicator” used by economists. 

This year has seen record-setting stock price movements as the stock market reacts to the onset and ongoing COVID-19 pandemic.  In March, stock fell 34% in just 33 days, the fastest bear market selloff on record.  Since then, we’ve seen the fastest rally on record as stock have risen over 60% in 8 months.

The Stock Market, The Economy, & COVID-19

So, economists will tell you that we are, technically, still in a recession.  Stock market pundits will tell you that we are up 15% for the year.  Why is there such a disconnect? We offer a few thoughts below.

Reason #1 – Investors or Employees?

The stock market’s performance only represents a portion of the U.S. employment market. A study conducted by the National Bureau of Economic Research showed that the wealthiest 10% of households in the United States were in control of 84% of the total value of stock shares, bonds, trusts and business equity and over 80% of non-home real estate. This was true despite the fact that half of all households owned a portion through mutual funds, trusts or various pension accounts. Therefore, the stock market may not display an equal distribution between those who make up the economy as a whole.1

Reason #2 – Today vs. Tomorrow

When we closed our economy in March, stocks clearly priced in the negative impact of lost earnings and higher unemployment.  However, stocks also factored in the powerful response by the Fed and Congress as well as positive news on vaccine development.  In other words, the stock market has been a decent predictor of future environments, therefore, it can move independent of (and counter to) current economic conditions.  

Reason #3 – Perception vs. Reality

It’s long been understood that at times, investors may be driven by emotional or irrational decision-making. For example, a business may report weak earnings due to the shutdown but state that future business looks great thanks to a backlog in orders. An investor in the business may react differently than an employee of the business who is out of a job. Further, how they feel about the economy or the stock market will be skewed by their personal experiences.  

At times, the economic data and the stock market can tell entirely different stories, as is the case with COVID-19. Understanding how these two components operate is key to understanding the signals they are giving.  Considering all relevant factors can provide a better depiction of the health of both the economy and your portfolio.

  1.       https://www.nber.org/papers/w24085.pdf

This content is developed from sources believed to be providing accurate information, and provided by Twenty Over Ten. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.