Why markets are up when the economy is down
WORDS ON WEALTH:
Why, when the world is experiencing its biggest economic crisis since World War 2, are stock markets soaring? Why the disconnect? There was a similar disconnect after the global financial crisis of 2008, when the financial markets recovered faster than the real economy.
The S&P500 index, widely regarded as the best representation of the US stock market, comprises America’s top 500 companies. This week, it surpassed its pre-pandemic high of 3 386 points, reaching more than 3 390.
In South Africa, the FTSE/JSE All Share Index (Alsi) has not quite recovered to its pre-pandemic level, but it is almost there. Its peak this year was 59 001 in mid-January, and for the past week or two it has hovered around 57 000. From its low of about 38 000 in March, that’s a pretty remarkable comeback.
So how does this compare with what is happening on the ground?
On the Visual Capitalist website, financial writer Marcus Lu quotes figures from the University of Michigan on consumer confidence in the US. The university’s Consumer Sentiment Index was down 26.3% for the year, as of mid-July. Lu notes that, in the past, this index generally moved in the same direction as the S&P500, but since March the two indices have diverged alarmingly.
In South Africa, consumer confidence has also plummeted. The First National Bank/Bureau for Economic Research Consumer Confidence Index, which has a range of -100 to 100, dropped from an already depressed -7 for the fourth quarter of 2019 to -33 for this year’s second quarter. The FNB press statement accompanying the results notes: “The latest CCI reading is now only three index points shy of the lowest consumer confidence level (of -36) recorded in 1985 – a year that was racked by violent resistance against apartheid, a partial state of emergency, president PW Botha’s infamous Rubicon speech and South Africa’s subsequent debt crisis.”
Why the divergence between investor confidence, as reflected in stock market indices, and consumer confidence? Economists and financial analysts offer the following explanations:
1. The weighted nature of the indices
The S&P500 and Alsi, along with other standard market indices, are weighted according to companies’ market capitalisation. This means a larger company makes up a greater proportion of the index than a smaller company. On the S&P500, a handful of giant companies dominate, and it’s these very companies that have prospered during the pandemic.
Lu notes that the US tech giants – Facebook, Amazon, Apple, Netflix, Google (now Alphabet) and Microsoft (known as the FAANG or FAANGM stocks) – significantly outweigh their S&P500 peers. While the market capitalisation of the average S&P500 company is $53 billion (about R900bn), the “big six” range from $200bn (Netflix) to $1.9 trillion (Apple). These shares alone make up about a quarter of the index.
On the JSE, one company, Naspers, and its offshore subsidiary, Prosus, dominate the Alsi, making up over one-fifth of the local index. Naspers has also done well during the lockdown, thanks to its large holding, through Prosus, in Chinese tech giant Tencent.
2. Outperforming sectors are masking under-performing ones
US analyst John Mauldin, in his weekly newsletter “Thoughts from the Frontline”, notes that the US economic recovery is not looking like a V, U or L, as suggested by economists with differing views, but like a K. In other words, the economy has split: some sectors are thriving while others are struggling.
In their regular monthly market commentary, Old Mutual Wealth investment strategists Izak Odendaal and Dave Mohr point to the variation in performance among the different sectors of the JSE.
“Those companies and sectors most closely connected with the local economy continue to languish. Bank shares are down almost 40% this year, and the diversified industrial and logistics groups are down 30%,” they say. “Mining shares have performed strongly on the back of rising dollar commodity prices and a weaker rand. The biggest winner, by some distance, has been the gold sector, which has doubled this year.”
A better indicator than the Alsi of the real economy are the FTSE/JSE Small and Mid-Cap Indices. Whereas the Alsi has recovered almost completely from its March plunge, these indices have recovered by only about 30%.
3. Government stimulus
This is the most frequently stated reason for the disconnect. Not since World War 2 have governments doled out so much to prop up economies. One way is through quantitative easing (essentially reserve banks printing money to buy government bonds) which proved effective in overcoming the 2008 financial crisis. Many governments, South Africa excluded, are using it again, on a far greater scale.
As before, the extra cash flowing into the financial markets is going into shares rather than safer interest-bearing investments, because of the hyper-low interest rates. Sanisha Packirisamy, economist at Momentum Investments, says policymakers “acted swiftly with measures and stimulus responses, which boosted riskier asset classes”. But while these asset classes have rallied, “the real economy is still showing some form of pain”.
4. Markets are forward-looking
Financial experts speak of known future events being “priced in” to the market. This means the price of a share immediately reflects any worries or optimism investors have about the effects an event would have on the company’s profits. Thus, the market is not a reflection of the economy as it is at present, but of how investors expect it to be in the future. And at the moment, despite much gloomy news about the pandemic, the extremely negative gross domestic product numbers, and the massive debt governments are taking on, investors are pricing in a strong bounce-back in economic activity.
In a recent Washington Post article, “As stock prices hit record high, economy trails behind”, financial writer David Lynch quotes Howard Silverblatt, senior index analyst for S&P Dow Jones Indices: “There’s always a difference between the market and the economy. We’re up because we’re looking past 2020 and looking at 2021.”
A word of caution: investor sentiment is a fragile thing – any news that dampens current optimism could send markets tumbling.