Global Economy vs Nasdaq100 (dividends not reinvested) compound growth rate, base=2005
Source: IMF, Investing-com, calculations by Income Markets
Let’s imagine that I have a crystal ball, it’s the last day of 2019, and I told you that in 2020 the European and American economy would contract by 7.1% and 5.9%, respectively, and that European and American tech stocks would go up by 8% and 30%, respectively. Surely you would say there’s no way stocks can go up so much when facing such a severe economic collapse, and that stocks should be a mirror of what happens in the real economy. If you said this, your logic was well-founded and made sense. Nonetheless, it isn’t what’s happening in 2020. But why?
This question keeps coming up, so I decided to share my thoughts, along with some numbers, on the issue.
The Covid-19 pandemic has inflicted and will continue to inflict acute economic pain to the masses. The total number of individuals who registered as ‘unemployed’ at the Portuguese Employment Institute (IEFP) has already surpassed the 407 thousand mark, a 37% uplift from last year. The Algarve has been particularly affected by the pandemic, and the region saw its unemployment rate shoot up by 216% Year over Year. This represents more than 23 thousand unemployed individuals in the region. Looking at Gross Domestic Product (GDP), a measure of all the wealth created by a country, Portugal witnessed a record-breaking 16.5% quarterly decline in GDP, in the third quarter of 2020. No matter where we look, the numbers don’t reveal any clear signs of optimism.
Consequently, stock markets can only be at, or near, all-time highs, right (irony)? Yes, despite the economic damage brought by the pandemic, stock markets, especially American tech stocks (Nasdaq100) are up by 30% since January. Apple has further enriched its position as the world’s most valuable company, having been valued at north of $2.1trillion in mid-September. At the same time, the IMF is predicting a 4.9% decline in global GDP. Let’s do some quick maths: if global GDP was close to $88 trillion in 2019, this represents the destruction of wealth totalling $4.3trillion. That’s 18x more than Portugal’s GDP in 2019!
More than frightening you with these dark numbers, I find it useful trying to understand what’s behind them:
1) The ‘real’ economy and the stock market ARE NOT the same beasts. They’re interconnected, but they often display different behaviours.
2) It’s important to understand that the stock market is driven by investor’s expectations of the future. Investing is all about buying the future at today’s price. In contrast, economic indicators like GDP and unemployment rate give us historical information and quantify what happened in the past. Analysing these indicators can be compared to driving while staring at the rearview mirror. This vital relationship was at full display in March. March 22 marked the bottom of the stock market, which had just recorded its steepest one month decline (35%). At the time, we had 292 thousand Covid-19 infections in the world. Today we have more than 34 million infections globally. It pays dividends to keep this in mind and understanding that the February/March crash was partially explained by investors’ expectations of a jump in infections cases, which did materialise.
3) When investing, results from economic indicators are only positive or negative when compared to expectations. If the market is discounting ultra-pessimistic expectations, but the data comes out slightly ‘less awful’ than expected, those are good news.
4) Central Banks have done an outstanding job in supporting financial markets. They’ve definitely done better than governments at supporting their local economies. As a response to the pandemic, Central Banks were quick to cut interest rates, which had the positive effect of easing debt burdens and facilitating access to credit markets – and credit is the blood of the economy. Central Banks also announced enormous stimulus packages. The European Central Bank, Federal Reserve and Bank of England announced stimulus packages valued at 7% of the Euro Zone’s GDP, 20% of the US’s GDP and 9% of the UK’s GDP, respectively. These funds tend to flow into financial assets before ‘trickling down’ into the real economy. In turn, this has the secondary effect of exacerbating the gap between financial assets’ prices and the real economy, and the wealth gap between the holders and non-holders of financial assets.
5) The news flow and sentiment around Covid-19 have remarkably improved since April. We’re now reading about late-stage trials and vaccines ready to be distributed, government-imposed lockdowns and similar restrictions have eased, and people have gone back to work and consuming (albeit at lower levels than pre-Covid-19). These developments, to name a few, lead to an increase in investors’ optimism, which lead them to position themselves as if the worst had passed.
6) Lastly, the numbers point to an increase in leverage and speculation by institutional investors but also by retail investors, who are usually less sophisticated and informed. Both groups have been happy to bid up prices in the big tech companies (i.e.: Apple, Amazon, Netflix, Zoom and Tesla). The prevailing rationale is that the sector will benefit from an increasingly digital world and that sales have gone up during the pandemic. I find it both funny and insightful to see that if we exclude these stocks, stocks haven’t recovered to pre-Covid-19 levels.
Performance of the 10 biggest companies VS the bottom 490 in the S&P500 (Jan-Sept 2020)
Source: TrendPlaybook.com, Bloomberg Data
João Feliciano Martins
ASCI, IAD, APP