COVID and the Market: A Case Study

Watching the economy and stock market do their respective dances, an investor may be tempted to wonder: Are they even listening to the same music?

This is especially true when the economy is moping through an extended dirge while the market does the jitterbug. Or the reverse: The economy is settling into a comfortable groove as the market collapses in exhaustion.

What explains these differences, and who hired this DJ anyway?

Here, we'll look at how the economy and stock market relate, using the past 18 months to show how investors attempted to divine the economy's stumbling path through the pandemic.

In general, the stock market moves before the economy does. Why?

"Stock prices are based largely on investors' expectations for the future," says Liz Ann Sonders, Schwab's chief investment strategist. "This generally means the probability of future profits, which are directly linked to economic activity, but also the future direction of monetary policy and interest rates."

In fact, trends in economic data tend to matter more to stock investors than their absolute level. As Liz Ann often says, "better or worse" generally matters more than "good or bad," when it comes to how the stock market looks at economic data.

This is why the stock market is considered a "leading" indicator. In fact, it is one of the 10 components of The Conference Board's Leading Economic Index (LEI), a bundle of economic indicators aimed at predicting the future course of the economy.

It also explains why stocks might surge while the economy is in freefall—as they did in the spring of 2020, the early days of the COVID outbreak. The stock market wasn't delighting in misery; it understood the power of the monetary and fiscal stimulus response, and was looking ahead to the recovery before it actually began.

This doesn't mean investors are always coldly rational. Their emotions also come into play, especially when the market is touching new highs or lows, or the economy is climbing a peak or wallowing in a valley.

As a result, the stock market isn't always "right," and unrealistic investor sentiment can sometimes have an outsized influence on prices. When that's happening, the market can seem like it's no longer running ahead of the economy—or other fundamentals of value—but completely disconnected from it. We've seen examples of that in recent months with the crazed swings in "meme" stocks, cryptocurrencies, and other speculative areas of the market.

And then there are those "black swan" events—surprises so sudden that they catch both the economy and the market unprepared. The start of the COVID pandemic serves as an example here.

The rapid collapse of both the stock market and economy early last year showed how forecasts and pricing mechanisms can fail in the face of the unexpected—and then rebound as the uncertainty clears. Stocks have had an extraordinary run since the COVID bear market ended in March 2020. We looked at every S&P 500® decline of at least 25% from an all-time high since the mid-1950s, and then tracked the subsequent rebounds. As you can see in the chart below, the COVID cycle outdid them all.

Companies in sectors that stood to benefit from pandemic-era lockdowns and restrictions performed well, at least as long as those restrictions were in place.

"As vaccinations and falling caseloads led to signs of reopening, momentum shifted toward those sectors poised to benefit most from an eventual return to normal," Liz Ann says. "And now the spread of the Delta variant of COVID looks as if momentum could shift again."

We compared the performance of both groups relative to where they started in March of 2020 in the chart below. The COVID winners have generally been in the Communication Services, Consumer Discretionary and Information Technology sectors; while the COVID losers have generally been in in the Energy, Financials and Industrials sectors. Note how they swapped positions in early March this year when the economic outlook was extremely bright—as well as how they've recently swapped places again.

Of course, COVID isn't the only concern driving the markets or expectations for the economy. Over the past year and a half, investors have also had to digest a spike in unemployment, government stimulus efforts, massive speculation in segments of the market, and inflation concerns. They are also trying to prepare for the Federal Reserve's plans to withdraw support from the economy, slowing earnings growth rates, and possible tax policy changes out of Washington.

Where the COVID winners and losers framework can help us identify broad trends in the recovery, looking at the more granular level of sector performance reveals the still-unsettled state of the economy. The chart below ranks the 11 industrial sectors by performance each month this year (along with the monthly performance of the S&P 500). Notice the way the various sectors of the stock market have rotated in and out of the top-performer's spot this year, providing a running commentary on how investors have attempted to make sense of these chaotic times.

So, what's an investor to do when the outlook is so unclear? A key takeaway here is that sectors rotate as economic conditions shift—and if you want to be positioned to benefit no matter who's in the lead spot, diversification is a pretty reliable way to do it.

"These shifts among sectors are happening quickly, so there's no excuse for not being properly diversified," says Liz Ann. "And that doesn't just mean across sectors. It also means across and within broader asset classes."

Beyond that, we always recommend investors practice good portfolio hygiene by sticking with a disciplined rebalancing scheme. Trimming investments that have grown in value, while adding to those that have fallen, forces us to do what we know we're supposed to do—buy low and sell high. The point here isn't to periodically grab all your gains and pile into "cheap" assets.

"Investors should never think of investing as either 'get in' or 'get out,'" Liz Ann says. "That's gambling on moments in time, while investing should always be a disciplined process over time."

As the preceding charts show, trying to seize a moment can mean missing out on bigger shifts happening around you. Rebalancing helps investors to be judicious and disciplined in order to build on successes over time, while avoiding the risks that could come with big all or nothing moves.