One observation that has come up frequently in conversations is the fact that the stock market has seen a strong recovery while the actual economy is still very much in the early stages of its own recovery. The below article written by my former colleague addresses this very topic and why these dynamics exist more often than one may think.

 

The U.S. equity market continues to race ahead, even as businesses struggle with the economic gridlock created by COVID-19 shutdowns and society grapples with the effects of racial injustice. We look at why it’s not unusual for Wall Street and Main Street to diverge from time to time.

 

Normally, equity markets face a wall of worry—and lately, there has been a mountain of worry. Yet following the initial steep COVID-19 selloff, markets have climbed the mountain successfully. U.S. and Canadian indexes are up almost 40 percent since the March lows, and major European markets are up about 30 percent.

 

With equity markets so buoyant during the economic crisis induced by COVID-19 lockdowns, and even drifting higher as the racial justice crisis has re-emerged, why does America’s Main Street seem so disconnected from Wall Street?

 

Investor optimism, policy pragmatism

Of course, there are practical reasons why equity markets are moving at a faster pace:

• Markets look forward, not backward, and they’re concluding that the current economic challenges will be temporary.
• The U.S. market seems to be assuming that the domestic economy and corporate profits will be back to 2019 levels sometime next year (we think it will be a little later).
• The Federal Reserve has thrown more than the kitchen sink at the severe economic crisis, backstopping the credit market for the first time in history. In hindsight, this has been a boon for the stock market and has supported valuations.
• Fiscal stimulus has also helped boost the market, in our view.

But this still begs the question, why aren’t difficulties on Main Street reflected on Wall Street during this period of severe economic and social distress?

 

 

Multinationals (often) move markets more

In reality, Wall Street and Main Street don’t always move at the same pace, especially when major non-market-related events occur. This has been the case throughout history. The profit trends and future prospects of companies within “the market” can diverge at times from wider problems in society, especially during unique challenges such as pandemic lockdowns, social justice struggles, or crises in government.

 

They can even diverge when segments of the economy come apart. One example is the savings and loan (S&L) crisis, which began in the 1980s and stretched into the 1990s. It took down more than 1,000 of these small financial institutions, or roughly one-third of the total, across the country. The crisis contributed to the 1990 recession and hit the U.S. equity market at that time (and some would argue that its nascent phase contributed to the 1987 bear market), but the S&P 500 began a sharp recovery rally in 1991. However, the S&L crisis had a much longer aftermath in the communities where many of these institutions were located, and continued to impact local small businesses for years.

 

 

Furthermore, “the market” is actually a narrower slice of private enterprise than it is often perceived to be. When the business press refers to “the market,” it usually is referring to the S&P 500, which represents roughly 500 large-cap (and mega-large-cap) companies at any given time, many of which are multinationals. This index includes big companies like Microsoft, Citigroup, Walmart, Honeywell, Chevron, etc. This isn’t Main Street.

 

Another prominent large-cap index, the Dow Jones Industrial Average—which still has the reputation of being “the market” among a lot of North American investors—is even narrower: only 30 companies, including most of those household names listed above.

 

Both of these large-cap indexes attempt to reflect the broad composition of the U.S. economy, but they certainly don’t capture the nuances of small and medium-sized business activity in cities and towns across North America.

 

The road ahead to economic recovery

Even during economic expansion cycles, gaps can open up between Wall Street and Main Street.

S&P 500 gains can far outpace GDP growth. In seven of the 10 economic expansion cycles since 1949, the S&P 500 price return exceeded the expansion in nominal GDP, according to Bloomberg Intelligence. In four of those cases, the market overshot GDP by wide margins.

 

And while the S&P 500 and GDP tend to move together directionally over the longer term—rising, falling, or treading water—they can diverge in the shorter term.

 

Thus far, the stock prices of most publicly traded companies have been able to shake off the negative impacts of the COVID-19 lockdowns, except for some at the epicentre of the lockdown recession, due to optimism about the prospects for economic and earnings recoveries. But mom-and-pop small businesses are just beginning to get back on their feet, and some have been knocked right back down due to widespread social unrest.

 

Coronavirus update

Some of the virus trends of recent weeks remain firmly in place. Positively, lower new infections in Canada and Western Europe. Meanwhile, Central and South America remain problematic, with Brazil reporting new daily cases that exceeded 30,000. On the other side of the world, India, Pakistan, and Indonesia are three countries that are struggling with containing the virus’ spread, with record daily new cases reported this week.

 

Investors remain focused on the U.S., where there are rising new daily cases across several states such as Texas, Arizona, California, and Florida, for example. Some of these states have indicated the average age of the newly infected appears to be meaningfully younger, which may help limit any strain on the health care system should hospitalization rates be lower. It is hard to pinpoint a cause of the rise in new cases, and it may be a result of a combination of economic reopening, mass gatherings, and a lack of mandated protective equipment. This latter point may be about to change as several states are considering making the wearing of masks a requirement in public.

 

China came back into focus this week after an outbreak of the virus in a Beijing food market. While the recent number of daily new cases has moderated, it has led to regional lockdowns, quarantining, and restrictions on travel to and from neighbouring regions. This outbreak comes after months of successful containment and illustrates the risk of the virus resurfacing in fits and starts.

 

Some positive news did emerge this week concerning a therapeutic. A well-known steroid called dexamethasone used to treat a range of conditions such as arthritis, asthma, and allergies was found to help the survival rates of some of the sickest virus patients. While details are still sparse, this could improve the ability of the population to cope with the disease.