This question was waiting for me when I opened my email this morning, July 6, 2020 and it’s a good question. It’s such a good question that I’ve been asked it dozens of times over the last few weeks. Many feel there is a disconnect between the stock market and the economy. Is there?
To be clear, I don’t want to discount the pain of what many have experienced from COVID-19, I’m only talking about the impact on the financial world in the following.
This is not an exhaustive list, but here are the five primary drivers I see behind the stock market’s rise of late.
1) The first is obvious: the Federal Reserve has said and continues to say that they will do everything in their power to keep this economy afloat. One of the first expressions I learned when I entered the financial services industry in the 1980s was, “Don’t fight the Fed.” Generally that expression refers to the Fed’s stand on interest rates but in this case it’s much broader. The Federal Reserve’s promise to sustain the economy is a big part of what is happening in the markets.
2) This one is not so obvious but I’ll lay it out for you because it’s important. It’s a concept called “market cap weighted index.” If it sounds complicated, it’s not. Let me explain.
First we have to understand what ‘market cap’ (capitalization) means. The easiest way to understand it is to look at an example. Let’s say company XYZ has one million shares outstanding. That is, one million shares are owned by investors. If each share is trading at $10, that means that stock market investors think XYZ is worth $10,000,000. One million shares times ten dollars per share equals ten million dollars. In reality some companies today have a market cap greater than a Trillion dollars (with a T).
Are you with me so far? Now that we know how to determine the market cap of a given company, we can more easily understand what “market cap weighted index” means and why it’s relevant to what is happening in the equity markets today.
Most indexes, such as the S&P 500 index, are “market cap weighted,” meaning they give more weight to companies with larger market caps. That means a trillion dollar company will move the market much, much more dramatically than a $100 Billion dollar market cap weighted company.
To illustrate, Amazon is worth north of a trillion dollars, meaning its market cap (number of shares outstanding times the share price) is over $1,000,000,000,000. If you added up the market caps of ALL the energy stocks in the S&P 500 they wouldn’t add up to the market cap of Amazon (or Apple or Microsoft or Google) alone. ALL of the energy stocks could go down in a given day, but if Amazon (and some of its high tech, high market cap brethren) were to go up that day, the S&P 500 would likely rise. Again because the index gives greater weight to these larger capitalization companies.
So, is there a disconnect between the stock market and worries about the economy, unemployment and other COVID-19 related issues? Maybe not when you consider that technology companies, in a monetary sense, are benefiting from the collective movement to living life online. Amazon is selling more products than ever and its stock price is going up as a result, dragging entire indexes up with it. It’s not just Amazon that is responsible for the market’s rise but it is representative of many high tech companies.
3) A headline from the Wall Street Journal of June 16, 2020 said “Investors Are Sitting on the Biggest Pile of Cash Ever.” As this money finds its way back in to the markets, the law of supply and demand indicates that stock prices rise. No one wants to be the last person in so likely that money moving into the market has something to do with what we see happening.
4) New York City. This is more about psychology than anything else but I believe it’s a key factor. New York City was the epicenter of the first real spike in COVID-19 cases and deaths in the US. Traditionally, New York City has also been the epicenter of all things financial. Most financial services are either based in New York City or at least have a presence there. This means that traders in New York have lived through life with COVID-19. They may have gotten sick, had friends and family members contract the disease and perhaps even lost someone they knew to it.
New York City has been beaten up by COVID-19 but has come through it. They can see what’s happening in Texas, Florida, California and other places and while they know it’s not pleasant, they know what it feels like to come through to the other side. If Houston, Los Angeles or Miami had been the first to experience a big spike in COVID-19, instead of New York City, I’m not certain we’d be seeing the lift in the stock market we’re seeing.
5) The stock market is often called a discounting mechanism. Consider this quote from Investopedia, “A discounting mechanism operates on the premise that the stock market essentially discounts, or takes into consideration, all available information including present and potential future events. When unexpected developments occur, the market discounts this new information very rapidly.” Investors globally are looking, not at today’s numbers, but what things will look like in six or twelve months. No one was surprised by big unemployment figures, investors already knew that. But where are we going to be a year from now? THAT’S where investors, particularly institutional investors, are focused.
We can find valid points on either side of the issue, but there may be good reason the stock market, as of today, continues to rise. Before you dismiss the recent run up in stock prices to ‘investors being out of touch with reality,’ as many feel, recognize that markets might be seeing the sprouts of an economy rebounding, even if it doesn’t feel like it today.