As I wrote on Monday, the near-term economic picture looks a fair amount worse now than it did a few weeks ago. What had been a rapid recovery in economic activity has turned into a stall, because a rise in COVID cases across the South and Southwest has caused states to freeze or reverse their economic reopenings and has made consumers more cautious about their behavior, even in less affected regions like the Northeast. When I say stall, I choose that word carefully — so far, the trend in economic activity since mid-June appears to be flat rather than falling. And since the economy has flattened out in a place with high unemployment and lots of businesses still closed, that’s a very troubling development.
All that said, the stock market has had quite a good few weeks. The S&P 500 is now higher than it was at its prior intra-crisis peak on June 8, and higher than it was at the start of the year. How could that be? Are the markets being irrational? Financial markets can always be wrong, but I don’t think the buoyant stock market and the stalled economy are necessarily in contradiction. Here, some good explanations for why stocks would appear to shrug off the very serious economic problems the virus has caused this summer.
First, stock prices are supposed to reflect market expectations of the future profits of corporations. I don’t love the phrase “the stock market is not the economy,” because stock prices can be an important economic indicator and shouldn’t be brushed off. But it’s definitely the case that the stock market reflects expectations about only a portion of the economy, and that it reflects expectations. There has been news in recent weeks that gives us good reason to believe companies will be less profitable this year than we would have thought a few weeks ago. But there has also been news about medical research developments that provides reason to believe companies will be more profitable in future years than we might have expected a few weeks ago. Investors have increasing reason to believe we will see widespread distribution of one or more vaccines by, say, mid-2021. That’s a positive development for the long-term outlook for the economy and for corporate profits, and so it should push stocks up, or at least offset the downward push from the bad nearer-term news. But you wouldn’t expect that good news about the future to show up in the current job creation or consumer-spending data.
Second, the most commonly discussed measures of stock prices, like the Dow Jones Industrial Average and the S&P 500, focus on very large companies. Because the companies in these indexes tend to have global footprints, the indexes are heavily influenced by the economic outlook outside the U.S. — including in other countries that have done a much better job managing the virus than we have. The S&P 400 mid-cap index, which looks at midsize companies that tend to have operations focused heavily on the U.S., is still down 10 percent for the year, even while the S&P 500 large-cap index is up one percent. In addition to having a more global footprint, large companies have more financial resources at their disposal than small ones do, and may be better positioned to weather a bad 12 months as they wait for vaccine hopes to come to fruition. The sorts of businesses least equipped to wait it out — small businesses, especially restaurants and bars — mostly aren’t traded on the stock market at all.
Third, interest rates have continued to fall, and low interest rates boost the prices of many kinds of assets, including stocks. You hear this discussed more often with regard to bonds: “Bond prices move up when bond yields go down.” That is, if you own a ten-year bond that pays 4 percent annual interest, and then interest rates fall from 4 percent to 3 percent, your bond will rise in value because its interest payment has become more attractive compared to what else is available in the market. You can think of a stock as having a yield like a bond: The stock share is a little piece of a company that’s expected to produce some amount of profits every year, and as other kinds of investments become less attractive, the amount you are willing to pay for that given stream of profits goes up. This doesn’t mean that a worsening economic environment where yields fall should actually cause stock prices to rise in absolute terms — unlike a bond that pays a fixed interest rate, the expected profits associated with a stock share should tend to decrease when the economy worsens, and that fact pushes stock prices down. But the fall in yields across asset classes should still partially offset the drag on stock prices from a deteriorated economic outlook.
For those reasons, I don’t think you should assume stocks are in a bubble, or that Wall Street investors have not admitted to themselves how bad things are right now. Things are very bad and have gotten somewhat worse lately, but things might look quite a bit better in a year, especially for companies that trade on the stock market.