With Economy So Bad, Why Are Stocks Up? Should You Buy?
People expect stocks to rise if the economy is improving and drop if it’s getting worse.
But I think that idea is wrong. So rather than feel confused because stocks are going up as the economy plunges into Great Depression territory, I keep investing in stock index funds every month — regardless of what the market is doing.
Why do people think stocks should follow the economy’s trajectory? It starts with the notion that a company’s stock market value should equal the sum of its future cash flows — discounted so cash received sooner is worth more than cash received later.
From here, it stands to reason that a healthier economy will boost the average company’s stock price. That’s because economic health creates a bigger pie — and if a company merely maintains its market share, its revenue and cash flow will rise accordingly.
Conversely, a shrinking economy should send stocks down because a company’s share of that shrinking pie will mean lower sales — which will cause the company to burn through cash (a result that can be made less bad through layoffs).
The Economy Is Getting Worse, Yet Stocks Are Rising
Based on this theory, it stands to reason that stocks should keep plunging.
After all, on May 8 the Department of Labor reported that U.S. hit a record unemployment rate of 14.7%, according to the Wall Street Journal. The actual economic misery is even worse because millions have stopped looking for a job, according to MarketPlace — a reality not reflected in the unemployment rate.
The economy is shrinking and likely to continue to do so. That’s because some 70% of economic growth comes from consumer spending — which dropped a record 7.5% in March — and April’s results are likely to be even worse.
With nearly 33 million people unemployed since the beginning of March — one-third of whom had not received their unemployment checks as of April 30 — consumer spending is likely to fall more. This could empower a vicious cycle in which a deeper drop in spending results in more excess capacity at companies which layoff more employees and further reduce consumer spending.
Indeed, Moody’s Analytics said April 8 that it did not expect the U.S. to make up all the jobs it has currently lost until 2023, according to the New York Times NYT .
Yet the S&P 500 — while down 10% since the beginning of the year — has rebounded 31% from its March 23 low.
With the economy this bad, why don’t stocks keep falling?
The COVID-19 Winners Are Beating And Raising
Here’s my favorite theory: Stocks move up when the biggest volume traders are net buyers and fall when they’re net sellers. By net buyers I mean that traders who want to buy are more eager than sellers are to sell, so the market will only clear if the buyers agree to pay a higher price. Net sellers means that market can only clear if the price drops because of the prevailing pressure to sell stocks.
This theory would be useful if anyone besides the high volume traders themselves knew whether they were planning to sell or buy and the reasons for that bet. Unfortunately, that is not possible.
Nevertheless, as I wrote in my 2017 book, Disciplined Growth Strategies, the beat and raise rule seems to explain why stocks move up and down. If a company exceeds analysts’ revenue and earnings targets and raises its guidance, the stock responds by rising. And if a company misses the targets and/or lowers its guidance, the stock usually falls.
This rule is slightly less useless than my theory about the high volume traders. That’s because it is possible to observe abrupt increases or decreases in purchasing behavior through so-called channel checks and other sources of non-traditional data — such as Numerator’s Weekly Shopping Behavior Index — that highlight changes in consumer behavior before companies report their quarterly results.
My beat and raise theory goes part of the way to explaining why stocks have gone up while the broad economy has collapsed. That’s because the COVID-19 crunch has created some big winners which came as a surprise to investors — enabling the winners to beat and raise when they reported their first quarter results.
It just so happens that many of these big winners — such as Amazon AMZN , Apple AAPL , Microsoft MSFT , Alphabet, Facebook and others — are among the largest components of the S&P 500 (together making up some 20% of the index, according to the Journal).
Why are these companies doing better than expected? People who are staying at home to stop the spread of COVID-19 and are spending their money and time in ways that boost demand for these companies’ products and services.
Instead of driving, using ride sharing or taking public transportation, eating in restaurants, going to movie theaters, taking cruises, attending a concert or football game, flying somewhere exotic for vacation, taking a cruise and shopping in stores people are using Zoom to conduct business, buying more from grocery stores, watching Netflix NFLX and YouTube, buying more from Amazon (and Wayfair W ), buying Peloton bikes since their gym is shut down, and using PayPal and other virtual means of paying for it all.
And the abrupt digital transformation of the economy is increasing demand for all the behind the scenes tools that enable companies to operate with employees at home — including the cloud, network security, and identity management.
Two other factors could explain why stocks are rising. With interest rates near zero — the 10-year Treasury Note yielded 0.69% on May 8, despite all the risks, they are the nicest house in a bad neighborhood (the S&P 500’s dividend yield is 2%, noted the Journal).
Secondly, since many of the high volume traders are hedge funds that are measured on how well they perform relative to stock indices, they mostly fear being left behind as the markets rise — thus forcing them to buy to keep from falling further behind the pack.
Obviously there are many industries whose survival is threatened. These include store-based retailers, newspapers, cable networks, oil and gas producers, restaurants, cinemas, concert promoters, health clubs, airlines, car rental agencies, aircraft and vehicle makers, and commercial real estate builders and owners.
Many of these — the store-based retailers, newspapers, cable networks, and cinemas — were on their way down before COVID-19. All of them are likely to continue to struggle unless or until the government bails them out.
There is plenty of uncertainty ahead. Who knows how much worse the COVID-19 pandemic will get as more states reopen despite a lack of effective testing for the disease or the widespread availability of vaccines of treatments? Have the stock prices of the COVID-19 winners already risen to reflect to increase in the present value of their future cash flows?
If you are not in desperate need of cash, keep investing in index funds. And stop expecting stocks to predict the economy.