Why the Stock Market and the Economy Actually Aren’t Disconnected
What’s up with this crazy stock market anyway?
Apple, Tesla, Zoom and their ilk have been going nuts, driving the Nasdaq and S&P 500 to record highs – and greatly enriching the billionaire class – (only to drop precipitously late this week.) All this while the economy is in recession and millions are unemployed – some even unable to put food on the table.
It’s yet another unsettling fact of life during COVID-19, though this piece seems particularly bizarre, nevermind unfair and even cruel.
So what to make of this so-called disconnect between the economy and stock market?
“The stock market and the economy are two completely different things,” says Barry Ritholtz, co-founder and CIO of Ritholtz Wealth Management. “While people assume that there’s some correlation, when you do a mathematical analysis the correlation is all over the place. 2020 is a unique year because not only is there a high level of inverse correlation, it’s the highest we’ve ever seen. The worse the economy has done, the better the stock market does.”
Actually it just follows that the stock market action would be particularly confusing during this particularly confusing, and unprecedented period in our history. It would be folly in fact, to expect a logical path.
Ironically for all we study and talk about the market, in many ways it remains a mystery. “Stock-market movements are driven largely by investors’ assessments of other investors’ evolving reaction to the news, rather than the news itself,” writes Yale professor and Nobel laureate Robert Shiller in “Understanding the Pandemic Stock Market.”
Still, when you drill down and closely examine the markets (big hint here: overall, stocks really aren’t up), the economy and in this case, science, the picture becomes more clear. I should also point out that explaining what the stock market is doing at any specific point in time is always vexing, while understanding it in retrospect is a piece of cake.
For starters, the most basic reason people attribute to strong stock market performance, is that yes, the economy is weak right now, but that the market always looks forward and ergo stocks are up because at some point (soon?) we’ll be out of this COVID-19 mess and can get on with our lives.
Which is certainly true, though if that were the only driver, I would say the market would be up just modestly given all the uncertainty. Of course there are all kinds of other factors in play here.
Let’s go through some of them.
Much has been made of retail investors, (aka the little guy, aka you and me), swooping in to buy stocks this year. “I think it’s playing a real role, though it’s difficult to quantify,” says Liz Ann Sonders, chief investment strategist at Charles Schwab. She gives credence to remarks made by Joe Mecane, Citadel Securities’ head of execution services, who told Bloomberg in July that “retail traders now account for about a fifth of stock-market trading and as much as a quarter on the most active days.” Jason Ware, chief investment officer at Albion Financial told Yahoo Finance’s The Final Round, “... that’s up 5% or 6% [points] on a year-over-year basis. It was 18% or 19% around this time last year.”
Who are these retail investors jumping into the market (which by the way has historically been seen as a negative sign) and why? Some call them Robinhooders, referring to customers – many of them young, first-time investors – of the eponymous fintech brokerage that’s been growing faster than summer corn. As for the why, well, what else are you going to do?
I asked legendary investor Mario Gabelli about them. “Individuals were locked down, Andy, those that were born on Fortnite and other e-games decided that we’ve got to do something. And so you had a new wave of day traders and speculators.”
Here’s what Mario means: Picture, the theory goes, a young guy working from home a few months ago, bored, staring at his laptop. There hadn’t been any sports to watch, nor any sports betting. Suddenly his buddy pings him and says he just made $1,500 in two days trading Tesla stock. He looks the next day and then the next week and the stock’s up again, the upward trend drawing more investors in. Time to open a brokerage account and join the party, right?
It’s all so easy. Most brokerages, including the aforementioned Robinhood, and legacy names like Merrill Lynch, Charles Schwab, E-Trade and Fidelity now have commission free trading, with zero minimum balances, and many of those same companies also offer fractional shares, (Schwab calls them ‘stocks by the slice’), so that if a stock price is too high, you can just buy a part. (For instance, Alphabet currently trades at $1,550, but you could buy a fraction of a share for say $150.50, whereby you’d own a tenth of a share.) Recently Tesla and Apple split their stocks, (from four digits to three digits) making them even more appealing and accessible to ordinary investors. (In addition, many of these young investors have been buying call options which tend to exacerbate stock moves.)
Commission free-trading with zero balances and fractional shares are relatively recent phenomena which serve to make trading that much more appealing as a pastime. Add to that the fact that many of the hottest stocks were the stay-at-home trades, or companies whose products the Robinhooders were constantly using – like Apple, Zoom, Peloton, Amazon, etc.
So that means the Robinhooders made the market go up?
The impact of day traders? “I don’t think the volumes are contributing a huge amount one way or another,” says JJ Kinahan, TD Ameritrade Chief Market Strategist.
“It’s tiny,” adds Ritholtz. “Vanguard has $6 trillion [in assets], BlackRock is $7 trillion. Robinhood is pocket change – a couple billion in assets. Most of the day trading, which is buying a thousand shares in the morning of xyz and selling it in the afternoon, makes no difference to the market.”
There’s also quantitative evidence according to the ever-astute Nick Maggiulli of Ritholz, who used data about Robinhood accounts (and from Yahoo Finance – thanks Nick), to see if there was “a high correlation between the change in the number of Robinhood users holding [a stock] and its one-day price change.” While Maggiulli did find some correlations, it was mostly in speculative stocks like Hertz, Kodak and Moderna, while “... stocks like Apple, Amazon, and Tesla show basically no correlation,” he writes. Meaning that while these investors may have an impact on prices of small stocks they don’t have any on big stocks and by extension the overall market.
You want to know what is big enough to move the stock market though? Try the U.S. government.
“We’re printing money like it’s going out of style,” Marc Benioff, CEO of Salesforce told me this week when I asked him about the market. (Salesforce stock has climbed more than 50% year-to-date – even after the recent decline – and was added to the Dow Jones Industrials Average at the end of last month.) “There’s so much liquidity in the markets today because of the massive flood of money that has been put in the system, creating massive inflation,” he said. “A lot of what you see in the stock market or if you look at what’s happened in a lot of these real estate markets in the U.S., you see massive inflation underway.”
True that Marc.
“The stimulus has been a massive support, particularly on the monetary side,” says Sonders of Schwab. “If you add in the fiscal side, you’re looking at 40% of GDP. When you pump trillions of dollars of liquidity into the economy and the economy is shut down, it means the economy can’t absorb liquidity. Where’s it go? Goes into assets. Not just the stock market, but commodities, precious metals, crypto. The Fed talks about generating inflation; it generated inflation in asset prices, not the real economy.”
But not all stocks have benefited from the Fed’s largess.
Yes the big tech stocks are up big time (to a small degree thanks to retail investors), but more because their businesses are doing well during the pandemic. Ritholz points out for instance that Apple, Google and Facebook get more than half of their revenue from overseas. “Why is that important,” he asks? “[Because] the U.S. is 4% of the world population and has a quarter of infections. The rest of the world is managing lockdown much better, so if half of your business comes from overseas you’re doing well.”
Which means these companies have healthy earnings streams and professional investors (and their algorithms) buy the stocks and the stocks go up. So a handful of tech companies are kicking up their heels, good for them, but it hasn’t really helped the overall stock market.
What about fighting the vaccine? “We’ve had some really positive and encouraging developments on the scientific front,” says Ware of Albion. “With vaccines, every card we’ve flipped over has been positive. Some therapeutics have helped us learn to manage and live with the virus. What used to be fear in March and April about deep, dark unknowns we’ve started to answer some of those questions this summer. While we haven’t solved them, we have a better idea of the path forward, and I think that’s certainly helped the stock market.”
But again, really the overall stock market? Yes a few high-flying biotech stocks like Novavax, Inovio, Moderna and BioNTech are lit, but even pharmaceutical stocks in general are no great shakes (down 5% this year.)
In fact, Sonders and Ritholz would argue the stock market writ large and the economy are actually on the same page.
“I actually think the market and the economy are less disconnected,” says Sonders. “If you look underneath the hood, what has been troubling to market watchers like myself, has been how concentrated the move up has been, really just in a small subset of stocks. As of two days ago, on a year-to-date basis the top five stocks in the S&P were up 48% and the bottom 495 were down 2%. Beyond the headlines of all-time highs, is the reality of very few dominant winners and a heck of a lot of companies left behind. To some degree that is reflective of what’s going on in the economy.”
Ritholz concurs. “Look around at what’s doing poorly in your neighborhood,” he says. “These companies are not publicly traded. The problem is that stock market indices like the S&P 500 are market-cap weighted, meaning the bigger company, the more it matters to the index. When you share the actual data, people are blown away.
“Department stores have fallen over 60% this year; but they’re 0.01% of the S&P 500. Tiny relative to other things. Airlines are less than a fifth of a percent of the index. If we were to take the weakest 30 sectors in the S&P 500 and remove them from the index, it’d barely be 2% of the total index.”
And conversely the big techs count a ton. Just six stocks: Apple, Amazon, Microsoft, Facebook, Google and Tesla now make up half of the Nasdaq 100. Those stocks are all up between three and 66 times more than the stock market this year. Earlier this week, Apple’s market value was more than the value of the Russell 2000 index (an entire index of small U.S. companies.) Tesla’s stock was recently up 1,000% over the past 12 months.
It’s all astounding. And incredibly distorting.
Bottom line: It isn’t so much that the stock market is up, it’s that stock market indexes that are up because of just a few stocks.
Most stocks like the economy are not doing nearly so well.
“Stocks are rarely priced well,” says Ritholz. “People forget fair value is just something stocks careen by on the way to being expensive or cheap. A lot now depends on how things progress. We don’t know what will happen. That’s why the bull and the bear case are so at odds. Our fate isn’t sealed.”
“You have to respect the downside of the market – it’s the most humbling instrument that exists,” says Kinahan of TD Ameritrade “I do worry people get lulled into security on the upside buying dips. It has paid off not only since March but over the last 10 years.”
Where do we go from here? It’s always the same answer.
By price earnings ratios, stocks are very expensive. By the dividend discount model (essentially using interest rates to value future earnings flows), stocks are still cheap. Yes that’s because interest rates are near zero, but that kind of divergence is unusual. Confusing even.
Welcome once again to 2020.