Insights

Sign up to receive exclusive financial insights:

Close

General

Wall Street vs. Main Street – Are the Markets and the Economy Connected?

Recently, Columbia Pacific Wealth Management has had many conversations about the apparent disconnect between what is happening in investment markets and the national and global economies. Commonly referred to as Wall Street vs. Main Street. Stock market indices have jumped off the lows reached at the end of March, to near record highs, while US economic output has had a much different path. Second quarter US GDP decreased at an annualized rate of 32.9%. Deaths from COVID-19 in the United States are over 200,000, 40 million Americans have filed for unemployment, and our country is in a divisive state over racial injustice. So, what explains this separation between Wall Street and Main Street?

Let’s start with the markets. Much of the bullish sentiment stems from the Federal Reserve, which has acted more dramatically than other central banks, buying assets on a historic scale. It is committed to purchasing even more corporate debt, including high yield “junk” bonds. The market for new issues of corporate bonds, which froze in February of 2020, has reopened in spectacular style.

Companies have issued double the normal level of bonds over the summer, even cruise-line firms have been able to raise cash, albeit at a high price. A cascade of bankruptcies at big firms has been forestalled. The central bank has, in effect, backstopped the cash flow of America Inc. The stock market has taken the hint and climbed. You can see in the chart below, the growth rate in M2 money supply (a measure of checking, savings, and investment assets) has gone parabolic. At the same time, the velocity of money (how often money changes hands) continues to sink—which is why “real economy” inflation has been kept in check. “Money printing” by the Federal Reserve (not quite an accurate description of what the Fed’s doing) only becomes inflationary if the cash pumped into the financial system comes out via the lending channels and picks up velocity in the economy. Without the velocity, inflation tends to be absent in the real economy—but quite evident in asset prices (like stocks).

Money Supply Goes Parabolic

Source: Charles Schwab, Bloomberg, Federal Reserve Bank of St. Louis, as of 4/30/2020. The velocity of money is the number of times one dollar is spent to buy goods and services per unit of time. If the velocity is increasing, then more transactions are occurring between individuals in an economy.

The surge in money supply is reflected on Main Street as well. The personal savings rates have surged to a 33% of disposable personal income, while at the same time, household net worth remains historically high. The combination of direct payments from the government to most taxpayers, and enhanced unemployment insurance, has benefited those affected by the coronavirus crisis with more than just good intentions. Recent surveys show that about 60% of laid off workers have been made more-than-whole relative to their work-based income prior to the pandemic. In addition, households have been in deleveraging mode since the Global Financial Crisis (GFC); with debt levels well below long-term trend lines.

Monetary and fiscal stimulus—and more recently news on virus treatments/vaccines—have fueled an epic run up from the lows in the stock market. Ultimately, equity prices depend on economic conditions and corporate earnings. There is a risk that the stock market is not accurately reflecting second-order and longer-term economic impacts of the virus and attendant economic shutdown (including bankruptcies and temporary layoffs becoming permanent job losses). There is also a risk that the stock market is not accurately reflecting the weakness yet to be fully felt in corporate earnings.

It shouldn’t be surprising that some companies have prospered during this upheaval while others—especially travel-related firms—have struggled. From its record high on February 19, 2020, the S&P 500 Index fell 33.79% in less than 5 weeks as the news headlines grew more and more disturbing. But the recovery was swift as well: from its low on March 23, the S&P 500 Index jumped 17.57% in just 3 trading sessions, one of the fastest snapbacks ever among 18 severe bear markets since 1896 (a prime example of why it’s important to stay invested and not react emotionally to market volatility). As of August 18, 2020, the S&P 500 Index had recovered its losses and notched a new record high.

At one level, this makes sense. Asset managers must put money to work as best they can. But is there something wrong with how fast stock prices have moved upward? This would seem to imply that commerce and the broader economy will get back to business as usual. Time will tell if the companies can follow through on current valuations.

Tellingly, though, the recent rise in share prices has been uneven. Even before the pandemic the market was lopsided, and it has become more so in recent months. Stock markets in Britain and continental Europe, chock-full of troubled industries like car making, banking, and energy, have lagged, and there are renewed jitters over the single currency. In America, investors have put even more faith in a tiny group of tech darlings—Alphabet, Amazon, Apple, Facebook, and Microsoft—which now make up a fifth of the S&P 500 index.

The stock market is a mechanism for aggregating opinions from millions of global investors and reflecting them in prices they are willing to accept, when buying or selling fractional ownership of a company. Share prices represent a claim on earnings and dividends off into perpetuity—current prices incorporate not only an assessment of recent events but also those in the distant future. This mechanism works on a constant basis and stock prices change when new information is processed by global investors and reflect in their willingness to accept higher or lower prices when they buy or sell. This is essentially the Efficient Market Theory. In some sense, the stock market has always been “divorced from reality” since its job is not to report today’s temperature but what investors think it will be next year, next decade, and beyond.

Moreover, the universe of stocks does not march in lockstep. At any point in time, some firms are prospering while others are floundering. This year’s economic turmoil has created hardship on some firms while opening new opportunities for others. Based on this admittedly abbreviated list, it appears the stock market is doing just what we would expect—reflecting new information in stock prices.

Past performance is not a guarantee of future results.

It is tempting to presume that economic growth should be closely related to stock market performance. The rationale being that stronger economic growth causes a spike in corporate profits, which in turn boosts earnings per share and supports higher stock prices. Despite this appealing logic, empirical research in recent decades has established that there is no clear relationship between economic growth rates and stock market returns. Indeed, cross-country studies suggest a low or even negative correlation between real GDP per capita growth and inflation-adjusted stock returns. Seasoned financial market observers have long been aware of such a disconnect between stock market performance and overall economic activity.

No one could have predicted the tumult we have seen this year in financial markets. However, it appears that investors who remained diversified and disciplined have fared well during these times. In conclusion, we want to highlight some key takeaways:

  1. Markets are forward-looking, so focusing on today’s economic data is akin to looking at the rearview mirror rather than the road ahead.
  2. Broad diversification makes it more likely that investors capture market returns there for the taking—including companies that do far better than expected. Maintaining an appropriate mix of cash/high quality bonds, affords investors time to hold onto risky investments through market volatility.
  3. Since news is unpredictable, a strategy designed to weather both expected and unexpected events will produce positive long-term results, while likely being less stressful. Staying tuned into the news cycle can help you remain an informed citizen, but is not likely to provide a reliable advantage to navigating financial markets.

If you have questions about investment markets and the national and global economies, contact us today.


Important Disclosure Information:

Different types of investments involve varying degrees of risk, including the risk of loss of your entire investment. Past performance is not indicative of future results. CPWM and its employees can give no assurance that the performance of any specific investment recommendation or investment strategy discussed herein, whether directly or indirectly, will be profitable, or that it will be equal to any historical performance level discussed herein. The discussion or information contained herein is not intended to be, and should not be deemed as, personalized investment advice. The recommendations made may not be suitable for your specific individual situation and we encourage you to discuss with your financial professional before undertaking any investment strategy or recommendation contained herein. The discussions contained in this blog is current only as of the date hereof and may change due to a number of factors, including varying market conditions.