Why the Stock Market Is Not the Economy

Upbeat music plays throughout.

Narrator: In the second quarter of 2020, U.S. gross domestic product, the chief tool used to measure economic activity, plummeted 31.4% after the first quarter's 5% decrease.

In April 2020, the unemployment rate hit 14.7% as businesses across the country shut down in response to the COVID-19 pandemic.

In short, the U.S. economy was a wreck. And yet, during the same quarter, the S&P 500^® posted a total return of more than 20%.

How could the stock market have such a major rebound in the midst of collapsing GDP and soaring unemployment? Well, for starters, the stock market is not the economy.

The stock market is forward-looking, meaning stock prices are based on expectations of companies' future earnings, not just present earnings. In that sense, it's possible for the market to be less impacted by current circumstances if investors feel there's a bright future ahead. The stock market rally in 2020 is a good case study.

In the depths of the pandemic, where was this confidence coming from?

It likely began with the aggressive and unprecedented maneuvers from the Federal Reserve, or "the Fed". To calm the markets, the Fed slashed interest rates to zero and began buying Treasuries, mortgage-backed securities, and corporate bonds.

When asked his opinion on the market in May of 2020, Torsten Slok, Chief Economist at Deutsche Bank Securities said: "This rally in equities is clearly not driven by fundamentals—it's driven by the liquidity support from the Federal Reserve. Companies are getting cash to keep the lights on through the significant support to credit markets."

Then, there were the stimulus bills from Congress, like the CARES Act, which increased unemployment benefits and provided direct payments to individuals.

In short, investors' confidence likely came from the government placing a large pillow under the economy to soften the fall.

Another factor that may have driven stocks up was a flood of new investors that entered the market.

The government stimulus funding, combined with a fear of missing out on the dip in equity pricing and zero commissions, helped drive a lot of interest in buying stocks.

At the peak of the pandemic, there was more free time and fewer entertainment options, like sports. So, some people turned to stock trading to pass the time. Also, with lowered interest rates, stocks were an appealing way to put money to work. Both these factors drove demand for stocks, pushing prices up.

It's also worth noting that the way stock indexes measure the market can make them unreliable indicators of the current state of the economy.

Some indexes, like the S&P 500, are market-cap weighted, meaning larger companies have a bigger impact on the performance of the index. This means the outperformance of a few huge companies can help buoy overall indexes.

For example, by June 2020, the S&P 500 was back above its 200-day moving average after rising 36% from its low on March 23.

FAANG stocks—Facebook, Apple, Amazon, Netflix, and Google's parent company, Alphabet, led the charge in the recovery rally.

Animation: Charts shows S&P 500^® performance by sector from March through May 2020. In order from best performing to worst: Consumer discretionary, information technology, communication services, health care, materials gained. Consumer staples, industrials, real estate, energy, financials, and utilities lost.

Narrator: But many sectors hadn't actually bounced back to the same extent. So, while measures of the overall stock market may tell one story, a closer look at specific sectors and industries may tell another.

But overall, in the case of 2020, the rosy expectations for economic recovery suggested by the stock market rally seem to have been justified.

By the end of 2021, GDP had bounced back, growing 7.0%, while the unemployment rate had fallen to 3.9%.

Whether it's government policy, investor behavior, or the way we measure the stock market, there are a number of factors that can cause a disparity between the stock market and the state of the economy at any given moment. The key point to remember is that the stock market is not the economy, but instead, a leading indicator of where investors think the economy will go.

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