It had been bugging me for a while. How can it be that, at the peak (so far) of the Corona virus pandemic, as we go into a deep recession, stock markets are in rude health?
There’s no doubting the seriousness of the recession. Any data you like will confirm that this will be the deepest economic downturn any of us has seen, dwarfing the 2008 slowdown, which was itself the worst since the Great Depression of the 1930s.
This chart shows data for the UK, but it’s the same elsewhere:
Makes you want to scribble ‘biff’, ‘kerpow’ or ‘whammo’ at Q1 2020.
And yet, after a short term blip, early in the pandemic, stock markets rapidly recovered to previous levels and, in some cases even posted record highs. I’m no economist, but surely, this is the opposite of what should be happening.
This is the weekly Dow Jones industrial average index performance from January to October 2020 (I know I’m mixing up US and UK data here, but the trends are the same):
Turns out I’m not the only person to have noticed. In October, McKinsey published a think piece entitled ‘Wall Street versus Main street: Why the Disconnect?’ dealing with exactly this inconsistency.
As they expressed it:
“In the middle of the deepest recession in memory, stock markets are reaching new highs. Why the disconnect?”
McKinsey’s analysis finds three points of explanation:
1.Investors are taking a long term view, so where there’s an underlying healthy business, they see that the investment prospects are still good once the recovery comes.
2. Stock markets, especially in the US disproportionately represent stocks like the tech giants, who are largely insulated against the worst effects of the pandemic.
3. Stock markets mostly represent big business, whereas it is smaller, unlisted companies who will be worst hit in the recession.
Hence they conclude, it is not to surprising that stock markets can do well while aggregate indicators like employment and GDP are severely depressed.
Sounds sensible, especially when we hear rumours of the massive financial gains made by a few billionaires during the pandemic.
On the other hand, I’m a little disturbed to observe quite how far the markets over-represent a few sectors – namely tech, finance and pharma. These three categories, according to McKinsey/Standard &Poor, make up 18% of the US economy, but nearly 60% of the market capitalisation of corporate America. As McKinsey summarises it, the market value of listed US companies, does not reflect the dynamics of the real economy.
Should it? Is it a problem if it doesn’t?
Either way, it helps explain why markets have a life of their own, seemingly independent of the real world of business.
Forbes Magazine goes even further, in a piece entitled This is why the stock market is rallying, while the economy tanks, concluding that stock markets are surprisingly healthy because they are simply predicting the recovery.
In their words, when the recovery comes, “the economy could grow very strongly ….. it could result in one of the fastest growth periods in US history”.
Are these commentators deluded?
Or are they simply optimists? (Nothing wrong with that.)
It does make you revisit the fundamental question – what is the stock market for?
When I studied economics, it was a marketplace, intended to raise money for businesses to grow, and in doing so, to extend ownership of those businesses to a wider group. Through supply and demand, the value of stocks would reflect the health of the businesses quoted and so, in aggregate, the health of the economy more broadly. But that was before the nature of the markets changed to focus on abstract investments like derivatives, futures and the opaque mysteries we now call ‘financial instruments’ with the resulting trend to speculative investments. Stock markets became casinos.
My instinct is to think more like The Guardian, where Larry Elliott explains the disconnect between the real and financial worlds thus:
The reason for that is simple. Financial markets were once seen primarily as places where businesses and governments could raise capital for productive investment. Over the years, the centre of gravity of western economies – and the US and the UK in particular – shifted from production to speculative finance, most of it debt-fuelled.
Should we be worried?
The reliance of pension funds, in particular, on the markets makes them one of those institution which has become worryingly ‘too big to fail’ ensuring they will be protected. Arguably, this in turn encourages reckless speculation, like that which created our previous worst ever recession in 2008.
So, yes, I’m worried. But the optimists are probably happier than me, so maybe I should be more like them.