Disjointed Reality - The Economy vs. The Markets
These days, reading a newspaper feels like looking into some alternate reality where things make very little sense. When you take rising COVID-19 cases with a level of social unrest we haven’t seen for half a century, and top if off with shockingly bad economic news, you get a pretty universally ugly picture.
There is, however, one exception: the markets. Of the 25 best days in the stock market over the last 50 years, 5 of those days were in March 2020. And after a 34% decline, the broad market (which we’ll define here as the S&P 500 Index) has dramatically rebounded by almost 60% from its low at the end of March, to the point where it’s now right around its all-time high.
Like many prognosticators and media personalities, you may be grasping for some logical explanation when the markets are swinging around wildly from day to day. Or, you may just be disillusioned and confused.
Although we’ve never had an economic and public health crisis exactly like this, it doesn’t mean we can’t look to history to help us answer a few key questions.
How can the markets and economy be telling such different stories?
Before exploring why the markets and the economy are seemingly on two different pages, we should start by explaining a key difference between them.
Finance types often describe the markets as “forward looking”, suggesting that the stock market tends to anticipate what might happen in the future. This makes logical sense when you consider what stocks really are, which is ownership shares of companies. That ownership share “buys” stockholders a piece of earnings in the form of dividends.
If a company is expected to make money in the future, investors might bid up the price of the stock, anticipating sharing in that good fortune. But if the company’s prospects dim, investors might think that its shares aren’t worth as much, causing prices for eager sellers to decline. Either way, investors are expressing their beliefs about the future, not so much about the current moment.
Alternatively, much of the economic data reported in the news (like unemployment or GDP) are “backward looking”, meaning that they are explaining the current state of the economy by looking at what happened recently. For example, we don’t know how many folks are unemployed until the government collects and analyzes the data on how many people have filed for unemployment benefits.
When the economy is growing and the stock market is going up (which is most of the time), we can be lulled into believing that the stock market and the economy will always be in lockstep. Based on our explanation of the difference between markets and the economy, however, it stands to reason that in times of rapid change (like a global pandemic or the financial crisis of 2008 – 2009), the markets and the economy likely will be sending different signals.
The bottom of the market almost always precedes the worst economic news, which means that there will be a time when the markets are marching upward, seemingly in the face of bad news across the board. Even as the economic data and news headlines are consistently bad, the market seems to know and be “pricing in” the fact that this, too shall pass, even if it doesn’t exactly know when or how.
The second key difference between the markets and the economy has to do with volatility. The economy typically moves at a slow and deliberate pace, punctuated every now and then by shocks to the system. Economic activity reflects people’s lives: their job status, their shopping activity, their income, how many houses are bought and sold, how many businesses are increasing or decreasing their production, and more. These things usually change gradually.
Financial markets, on the other hand, can and do change in the blink of an eye. News is quickly incorporated into the prices of stocks and bonds, particularly when all it takes to buy or sell is the click of a button. Sometimes the mood of the market can change drastically within a day, or even a few hours, based upon seemingly nothing.
Over time, the markets and the economy typically will get to the same place. But predicting or explaining the market’s behavior on any given day is impossible (no matter what the financial news might lead you to believe).
Has this happened before?
Although we’ve never had a COVID-19 global pandemic before, we have experienced economic and public health catastrophe, and this pattern of the economy and the markets periodically moving out of sync is not new. For example, in our country’s darkest days during the last few years of World War II, the stock market nearly doubled.
Also, it’s worth noting that the best days in the history of the stock market have historically occurred right as markets were “bottoming”, reflecting panic and pessimism. The old adage, “The night is darkest just before the dawn” applies here. For long-term investors, it is critically important to remain invested for these big upswings in the market, which is notoriously hard if you are trying to time the tops and bottoms. This makes it critical that you stay in your seats, even when the daily swings in the market feel unbearable. When the news is worst, the opportunity tends to be the greatest.
Should I be worried? And what, if anything, should I be doing now?
These are concerning times for all of us. We’re all worried about our friends, families, and communities. However, from a market perspective, history gives us a pretty reliable playbook for how to handle these situations: remain calm and stick to the plan you made in quieter times. Sometimes the hardest (and best) thing you can do is to ride the roller coaster and stay focused on your goals for the long-term.
Written by Vic Colella, CFP®