Why Are the Economy and the Stock Market so Divergent?

By Amit Rupani, CFA

Taking stock of the Stock Market

As I write this in mid-August, the S&P500 is less than 1 percent away from surpassing previous all-time high of 3393.52 which was reached on February 19, 2020. NASDAQ has already surpassed its February highs by about 11 percent. In less than six months, S&P500 has made a roaring comeback and it's up ~54 percent from March 23 low of 2192 levels. At the face value it seems as if the market has completely shrugged-off the health and economical damage done by the COVID-19 pandemic.

But if we look beneath the surface, we see that the restaurants, cruise lines, airlines, hotels, retailers, malls, movie theaters, resorts, and many other industries are still many miles away from their February 2020 levels. This makes complete sense. These are the businesses which have been impacted the most by “new normal" lifestyle of the pandemic with no clue on when the normalcy will return. And hence their prices have been hammered the most without any meaningful recovery. Let's call them pandemic losers.

Some businesses have gotten huge tailwind thanks to the change in consumption patterns due to this pandemic. By far technology businesses have been the biggest beneficiaries. Different flavors of technology businesses like e-commerce, e-healthcare, online meeting solution providers, online streaming, electronic payments, electronic signature, in-home work-out, home remodeling, interior home goods have benefited the most. Other defensive sectors like consumer staples (groceries), telecom, and healthcare have also gotten some tailwind but not as much as the technology sector.

So, the bulk of heavy lifting is done by technology and e-commerce businesses in bringing S&P500 close to its February peak level.

Taking stock of the Economy

Unemployment rate was 3.6 percent in April 2019. Since the advent of stay at home orders beginning in March 2020, in April 2020 the US economy lost a record 20.5 million jobs, and unemployment hit 14.7 percent . Unemployment fell to 10.2 percent in numbers that came out in July.

Real gross domestic product (GDP) decreased at an annual rate of 32.9 percent in the second quarter of 2020, according to the “advance" estimate released by the Bureau of Economic Analysis. In the first quarter, real GDP decreased 5 percent.

Current-dollar GDP decreased 34.3 percent, or $2.15 trillion, in the second quarter to a level of $19.41 trillion. In the first quarter, GDP decreased 3.4 percent, or $186.3 billion.

Experts are predicting that it will take a few years before we get to Pre-COVID employment levels and GDP numbers. Fed Chairman Jerome Powell warns that the path of the economy depends on path of the coronavirus.

Why this Divergence?

The stock market is always forward looking. Most of the times, the stock market turns down prior to recession and rises before economic recoveries. Market index peaked on average 5.4 months before the beginning of a recession for the post-World War II recessions until 2011. And market index has bottomed about 4.6 months prior to the economic recovery of these recessions.

Some of the possible reasons which may explain current market recovery are low interest rates by the Fed Bank and also providing unlimited liquidity, various direct benefits given to impacted people by the Federal Government ensuring consumption is not impacted and helping small businesses as much as it can, hope for vaccine in immediate future, and lack of investment alternative given bonds are not yielding much.

This COVID-19 pandemic has been unique in a way that everything so far has happened very fast. We went down fast and rebounded rapidly. Many smart investors who missed out on this rally are still scratching their heads at the speed of this recovery in the market indices. But patient investors who sat through March and April volatility or perhaps even bought at attractive lower levels are looking at smart quick gains.

It's a given fact that for every dusk there is a dawn. Even the darkest night ends giving way to the sunrise. Some years we may have a long, brutal winter but it is always followed by a blooming spring. Similarly, for every recession there has been an economic recovery. Some recessions may take longer to end, but no recession has lasted forever. It's in the nature of economic environment to be cyclical and so are the stock markets. It's just that the stock market always moves ahead of the general economy. A patient investor's job is to just buy-right and sit-tight through these cycles and enjoy the power compounding through equities asset class which has never disappointed in the past.

Happy Investing!

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Amit Rupani, CFA is an Independent Investor, practices Value Investing principles, manages money for long-term wealth creation through Equities asset class. Email: rupaniamit@yahoo.com