The Great Divide: Analysis of the Stock Market and the Economy

The economy is in a recession, but the stock market is up. What is going on?

By Avi Gupta

The Stock Market is the most recognizable financial system in the world. Not only to the thousands of traders who actively speculate on the market, but also to the average American citizens who proudly hold a fraction of the greatest companies ever to exist. The stock market is looked upon to report the status of the economy, easily seen by the mentions in the media of the major indices and corporate giants. That being said, Covid-19 has highlighted a disconnect between the equities market and the economy. The Economy is in recession, but the Stock Market is up. How did this come to be and why?

To evaluate why a disconnect exists, first, an understanding of the Stock Market is necessary. The Stock Market is a market where ownership shares of a company are bought and sold. Thus, the value of a company can be calculated by multiplying the price and quantity of shares to find the market cap. Generally speaking, one company is not very telling of the economy, but by looking at indices which are collections of companies, the growth rate of these companies can be charted and by result the economy. Except that is not completely true. 

The Stock Market is comprised of publicly traded companies. For a company to become publicly traded, it requires an Initial Public Offering (IPO) that employs the services of major financial services firms. The specifics of such a process is outside the scope of this article, but the important common factor of all these companies is that they have a long financial record, and there is an interest to buy shares of this company, usually entrancing investors with potential growth. Very few businesses meet these criteria. Thus, out of the hundreds of thousands of businesses in the United States, only a small fraction are publicly traded. After evaluating the effect of an economic disruption such as Covid-19, a systematic impact (Affecting the whole economy) is apparent, leading to an extreme burden being placed on every business big or small. That being said, publicly traded companies have a financial record and access to lines of funding small businesses can’t even dream of. So as an economic recession forms, the bigger business on Wall Street can float above the wave that has destroyed thousands of businesses across the US. 

This explanation shows a disconnect of sorts, but not to the extent that is seen today. Why is it that while unemployment is over 8% and an intangible amount of economic damage has occurred, the stock market has not only settled but has generally risen? There are multiple reasons:

First, after the Information revolution of the 1990’s and 2000’s, major tech firms have become financial giants, and make up five of the top ten market caps. Technology firms have suffered fewer losses by the disruptions in supply chains and flow of human capital, and have even benefited by the greater reliance on technology solutions to everyday problems. It is important to note that generally revenue for tech firms have decreased, but market cap has increased because of the increased dependence on technology.

Second, market caps are driven by speculation. Stock Prices, and by extension market caps, are traditionally thought to be defined by the Dividend Discount Model (DDM) which defines inherent value by all possible revenue discounted for time. This is a logical assessment of stock prices, but not all investors base their trading decisions on logic. Every stock has a speculative aspect which drives the price forward beyond the DDM. Looking at the case with tech firms, due to Covid-19 preventing many in-person interactions, technology firms were expected to fill the gap and investors speculated as such. The issue with speculation is that if the price is no longer remotely calculated by the DDM, bubbles form that have previously destroyed whole industries, as everything that rises must come down, such as the Tech Bubble in the 2000’s.

Third, the stock market is a good investment. The Stock market is considered riskier than most other investments, most notably fixed-income investments or bonds. That being said, the stock market swings in the short-run, but in the long run grows relative to the economy, especially when looking at diversified indices. Thus, even with the risk, the reward is worth it for many investors. Arguably even more so when an economic recession occurs. As any other market, the Stock Market has many substitute markets with the closest being the Bond Market. Thus, as the Fed has decreased interest rates lowering the yield of the whole bond market, investors have flocked to the stock market where the returns are much greater than the 1% from treasury bonds and higher than corporate bonds. Although some may argue that when in panic, investors buy treasury bonds, which is true, such purchasing pushes the yields of treasury bonds even lower. Investors who are risk-neutral, or risk-tolerant, reassess risk vs yield as treasury yields crash, and move toward the stock market.

In conclusion, the Stock Market has risen even through an economic recession for the above mentioned reasons. This disconnect has always been present and has grown in the last few decades, but the disconnect should warrant an even closer eye on the Stock Market not less. Although the Stock Market cannot comment on the state of the economy, it not only provides insight into company valuations, it shows what the expectations are for the largest companies. Even though it’s a small segment of total business in the economy, these publicly traded companies represent an insurmountable amount of wealth. The top firms can make the same impact as thousands of smaller businesses, and thus they move markets and their actions affect everyone. Thus, now more than ever their actions deserve to be on the front page of every newspaper. □


Work Cited

  1. Image source
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