When we think of financial health, a few things may come to mind, such as our own financial status, our investments, stock market performance, or the overall economy. While some of these aspects may be interrelated, they are not all one in the same, nor do they all indicate the status of one another.
The various ways we can characterize financial well-being speaks to why so many people think of the stock market and the economy’s health as a gauge for one another. However, the stock market does not define economic health. As we have seen throughout the COVID-19 pandemic, stocks are 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. So why is this? Below, we outline the major differences between the stock market and the economy and why one can progress while the other may tell a different story.
What Is the Economy?
The economy can be defined as the overall wealth and resources of a country as it relates to the production and consumption of goods and services. More specifically, one way we can understand economic activity is through real GDP (gross domestic product), which measures the value of goods and services while factoring inflation into the equation. As a result, understanding the health of the economy can be thought of in terms of the growth rate of real GDP, meaning whether the production of goods and services is increasing or decreasing.
Economic Health in Terms of GDP and Employment
Naturally, employment may rise as production and consumption increase. To produce more goods, companies and factories might hire more employees to complete such production. With more individuals employed and gathering paychecks, more people have money to spend on goods or services - increasing overall consumption. Sometimes, however, GDP can grow but not quick enough to create more jobs for those who are unemployed. Other times, while GDP may be growing, improved productivity growth allows companies to grow without adding employees through better automation or more efficient equipment.
What Is the Stock Market?
The stock market is simply an exchange where individual company stocks are bought and sold. It is the buying and selling of ownership shares in a corporation. The stock market is thus comprised of buyers and sellers (with some buyers and sellers holding more “stock” than others) and is not necessarily indicative of every business, worker and family.
Some of the main indexes used to understand how the market is performing in the U.S. are the Dow Jones Industrial Average (tracking of 30 leading companies), the S&P 500 Index (500 stocks across all industries), and the Nasdaq Composite Index (a dynamic mix of 3,000 stocks across the technology, biotechnology and pharmaceutical sectors). Each of these measure the performance of stocks using a different methodology and company and sector makeup.
The Stock Market vs. The Economy in the Context of COVID-19
The stock market and the economy can display very different pictures of “progress.” One such example is with COVID-19. In regard to the stock market, the major indexes including the S&P 500, the DJIA and the Nasdaq Composite index all have surged since the market downturn in March. On the other hand, GDP decreased by an annualized five percent in 2020’s first quarter and 32.9% in the second quarter (the worst quarter in history) according to the U.S. Bureau of Economic Analysis. When looking at employment, with data from the U.S. Bureau of Labor Statistics as of July 2020, the percentage of unemployed individuals stood at 10.2%. While this is down from its peak of 14.7% in April, it’s still higher than the sub 4% levels we saw to begin the year. So why is there such a disconnect?
When considering the make-up of the S&P 500, the DJIA and the Nasdaq Composite index, the stock market isn’t necessarily representative of the entire U.S. economy. It is largely made up of companies that are larger in size - with different profits, greater access to bond markets and global positioning. So as many have seen, larger business with better access to financing, have been better able to withstand the lockdown than smaller businesses. As an example, in retail, those that had a large online presence or were deemed essential, like the big box stores, have taken market share from smaller retailers.
In addition, the gains of the major indices have been led by a narrow list of companies, primarily in the technology sector. In fact, according to S&P Dow Jones Indices, Microsoft, Apple and Amazon now make up over 16% of the S&P 500. So, while these larger technology related companies have done extremely well of late, benefitting from increased spending in this area amidst the pandemic, many other smaller companies or companies in other industries are still down from their highs earlier in the year.
The stock market’s performance as a whole only benefits a portion of the U.S. employment market. A study conducted by the National Bureau of Economic Research showed that the wealthiest 10 percent of households in the United States were in control of 84 percent of the total value of stock shares, bonds, trusts and business equity and over 80 percent of non-home real estate. This was true despite the fact that half of all households owned a portion of the market 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, as the gains tend to go to the wealthy, while those lower on the economic ladder do not participate. This can create a divergence in the economic realities of wealthier individuals, who have benefitted from stock price appreciation, and the not-so-wealthy whose economic situation is more reliant on jobs and wages.
It’s long been understood that at times, investors may be driven by emotional or reactionary decision-making. As a result, their behavior may not be mimicking the economy’s current state nor affairs happening in real-time. The equity markets in general have historically been an advance indicator of the state of economy, falling before a downturn and rising before an upturn.
While the stock market may reflect some changes in the economy and vice versa, the status of one does not show the entire portrait of the other. At times, they can tell entirely different stories, as is the case with COVID-19. Considering other factors such as unemployment can provide a fuller depiction of the state of the economy and the financial well-being of its residents.
Currently, most investors seem to be factoring in the fact that a vaccine will be available in the not-too-distant future. In essence, calculating that this is a short-term event and that the long-term value of stocks will be unaffected, with the economy being back to normal by 2021. With this stance the stock market is masking the fragility of the current economic situation. Any alteration of this narrative could send the market down to levels that better reflect the current overall health of the economy.
In addition, the Federal Reserve and various fiscal measures such as the CARES Act have been a tremendous backstop to keep the economy operating as efficiently as possible under the circumstances. Without this support, the economy, and likely the markets, would be on shakier footing. Once again, like the expectations for a vaccine, investors are assuming monetary and fiscal policy will be there to support the economy and asset prices, until the virus is over, and things return to a semblance of normalcy. While not completed as of this writing, hopes remain for a new stimulus bill if both sides can come together that can continue to help the unemployed along with consumer spending.
The disconnect between the economic realities and equity market performance is the largest I have ever seen. The equity markets are currently forward looking and betting the economy will return to more normal levels by 2021 in terms of GDP growth and employment levels, albeit pushing valuations to historically high levels. With interest rates low along with government stimulus efforts, the economy has received a boost to get through this hopefully short-term virus-related downturn. Prudence may be in order when looking to buy risk assets, like equities, based primarily on the actions of a third party (Federal Reserve) over analyzing market fundamentals. While the path of least resistance appears to be higher in the equity markets, any setbacks that would keep the economy returning to normal by 2021 will likely have negative repercussions for stocks.
Jeff Spitzmiller is the CEO of Ohana Wealth & Life Planning based in Cincinnati, OH. Ohana specializes in life and financial planning along with ESG (Environmental, Social, Governance) investing principles. The firm is an independent financial advisor and a fee-only fiduciary. Jeff and the firm also enjoy volunteering and giving back to the local community. You can reach Jeff at firstname.lastname@example.org.
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