Does it seem to you that the stock market is totally disconnected from the reality of the economy?
Business news has been as bad as it gets. The number of unemployed workers has reached record-setting levels while GDP has declined to levels not seen since the 1930s. Federal debt has increased by more than $3 trillion. At the same time, the federal government’s response to the COVID-19 pandemic has been erratic and leaderless. Yet the S&P 500, after losing more than 30% in March, has bounced back nearly 50% since that time. What’s going on?
Actually, the market is behaving quite normally. It’s important to recognize that markets are forward-looking. That is, current asset prices reflect investors’ expectation of future corporate earnings. Although the currently reported economic data sounds bleak, investors are not basing the prices they’re willing to pay on how companies are performing today, but rather on how they think they’ll be doing multiple quarters into the future.
This behavior has been demonstrated statistically by Dimensional Fund Advisors, which plotted annual GDP growth against the same year’s equity premium. That’s the stock market return above the return from risk-free, one-month U.S. Treasury bills. No discernible relationship was found between the two over the past 90 years.
Then Dimensional Fund Advisors compared the same GDP growth against the previous year’s equity premiums. The trend between the two is clearly positive. The higher the previous year’s returns, the higher the following year’s GDP growth.
This isn’t to say that the stock market always gets it right. As you can see from the outliers, there have been years when equities were positive but the following year’s GDP growth turned out to be negative, and on rare occasions vice versa. Note also that the vast majority of years both GDP growth and stock market growth have been positive.
The point, though, is that the market does appear to be pricing in expectations of future rather than current economic activity. Even more interesting is how well they seem to track.
What is the market telling us today? Investor sentiment is largely optimistic with respect to the economy bouncing back fairly quickly, which also means assuming that the COVID-19 pandemic will be brought under control in the not too distant future. Could this change quickly? Certainly, if something unexpected were to happen over the next few months. For the present, however, millions of investors see things improving over the next year. That’s encouraging to me!