Abacus: The Unusual Relationship Between Stocks and the Economy
To many people, the stock market and the economy are synonymous: when one trend in a certain direction, so too does the other.
In reality, the relationship between stocks and the economy is far more complicated than many people truly realize. Even for many individuals who believe they have a good understanding of how the stock market tends to operate, periods filled with uncertainty, like the one currently experienced by investors during the COVID-19 pandemic, can lead to perplexing feelings regarding financial markets.
To gain a better grasp of how markets often work in such times, it can be useful to review the fundamentals of the stock market. One of the biggest factors that contribute to the share price of a company’s stock is expectations regarding the company’s future earnings.
A lot of factors go into determining a healthy economy, the stock market being one of the most popular.
A myriad of other factors can affect stock prices in general; expectations of earnings are perhaps more important above all other influences on the worth of company stock. One reason why earnings are so important concerns the value of dividends.
Dividends are payments paid out by certain corporations to their shareholders as a form of compensation for taking on the risk of investing in their company. Typically, the more shares an investor holds in a company, the larger the dividend payments they receive.
If a company’s earnings are expected to rise in the future, that firm will likely be able to afford to pay out higher dividends. Companies may increase their dividend payments in order to induce people to purchase an additional stock because many firms use the stock as a method of raising capital to finance ventures.
Stock is a good measure of raising capital to finance ventures
As a result of larger dividend payments, investors will be tempted to buy more shares of the company in hopes of earning more profits. The purchase of additional shares lowers the total number of shares of stock available, which in turn makes each share more valuable, and thus more expensive.
Given the importance of a company’s earnings to the share price of the stock it issues, it is interesting to examine how specific economic indicators affect the outlook for earnings, and thus share prices.
Consider one of the major economic variables that many investors care for: Gross Domestic Product growth rates.
GDP measures total economic activity, with large growth rates typically signifying high levels of consumption and business investment. If incomes are high, consumers have an incentive to increase their spending, which in turn leads to more company sales, which helps generate high earnings for big companies.
When economic activity contracts, as has been the case during the pandemic, unemployment tends to increase, which has an adverse effect on the demand for certain goods and services.
This sequence of events has been particularly significant during the current recession, as many industries that help drive certain economies, such as the tourism and service sectors, have largely seized business as a result of government-instituted lockdown, barring even risk-preferring individuals from partaking in events.
GDP measures total economic activity, with large growth rates typically signifying high levels of consumption and business investment.
Consequently, earnings forecasts for companies are likely to be bleak during recessions. Real GDP decreased at a 5% rate in the first quarter of 2020 compared to the same period last year, the quickest shrinkage since the global financial crisis in 2008.
As the coronavirus spread across the globe, shutting down some of the nations’ biggest economies, like China and the US, stock prices fell at their greatest rates since the housing crisis of 2008. The value of the Standard & Poor’s 500, one of the benchmark stock indexes in the US that value 500 large companies listed on the US stock exchange, declined 33.9% between February and March as investors grew increasingly wary of the virus’s effect on worldwide economic growth.
For many ordinary middle-class Americans with savings linked to the stock market, a severe slide in stock prices can lead to great feelings of unease about the future.
As a result, many individuals may decide to sell some of their own assets out of fear that the markets will continue to slide, further contributing to price declines.
As economies faced their worst conditions since the Great Depression, investors looked to various policies implemented by the government for signs of optimism in forecasts for the future, specifically, as it concerned earnings projections for businesses.
One of the most noteworthy moves made by the Federal Reserve, the US central bank, was their decision to reduce interest rates.
While there are several different types of interest rates, most of them tend to move in the same direction. The benchmark interest rate that the Fed concerns itself with is the federal funds rate: the rate that institutions like banks charge other financial institutions for lending money.
Not long after the Fed reduced the federal funds rate to close to 0%, investors saw signs of hope for eventual growth.
Effective Federal Funds Rate/ (Source: Board of Governors of the Federal Reserve System)
There are two primary reasons why low-interest rates have a positive impact on stock prices. First, they can lead to higher earnings for companies: low-interest rates incentivize businesses to invest in projects at low costs, and they also encourage consumers to finance large purchases, such as automobiles and homes.
Second, low rates imply smaller returns on assets such as bonds, certificates of deposits, and savings accounts. When faced with the choice of earning very low yields on securities that are nearly guaranteed to pay their holders a return, or buying assets that are certainly riskier but have historically offered more lavish long-term gains, investors may be more inclined to invest in the latter.
In addition to reducing interest rates, the Fed promised to engage in several unparalleled actions to maintain the stability of markets and the banking system.
The Federal Reserve has the responsibility to oversee the federal interest rate and adjust it to help maintain healthy markets
Perhaps most notably, on March 23rd the Fed promised to purchase an indefinite amount of securities in the treasury and mortgage-backed asset markets in order for financial markets and monetary policy to function normally.
Furthermore, the Fed maintained the belief that small businesses should be supported during the downturn, specifically as it related to banks’ willingness to lend money to small firms. The central bank gave support to a $349 billion lending program for small businesses, funds that were intended to encourage banks to engage in lending with businesses that would have otherwise faced difficulties in raising capital.
The announcement by the Fed to help the financial foundation of the US no matter how badly the coronavirus wrecked the economy brought optimism among investors, and a quick surge in stock prices emerged.
The S&P 500 gained more than 44% in value from March 23rd to June 8th before experiencing more volatility. Some of the companies that have enjoyed considerable gains during the pandemic include technology firms, as people typically spend their time in quarantine using electronic devices such as smartphones, tablets, and computers.
Indeed, the tech-heavy Nasdaq index rose an outstanding 48.8% between March 23rd and July 2nd, reaching an all-time high.
As financial markets have recovered, the economy has yet to experience anything akin to the rebound of stocks. Starting in late March when many stocks started to recoup their value, investors likely entered a period known to many in the fields of economics and finance as “irrational exuberance”.
Such a time typically occurs when people become overly enthusiastic about the value of certain assets without paying much regard to any evidence that supports such eagerness.
In the case of stock markets between late March through early June, investors likely became excessively excited about the number of new COVID-19 cases decreasing in many states and the Fed’s willingness to aid the financial system.
Many are watching their financial livelihoods crumble as work becomes harder to find in the Covid-19 Economy
Despite these positive signs, the economy remained in one of its worst states in modern history, with more than 42 million claims for unemployment insurance filed between late March and early June. When people lose jobs, especially those that offer relatively low income and have been substantially affected by the lockdowns, such as positions in the service sector, aggregate purchases of non-essential goods dramatically decline.
Such a dramatic rise in unemployment claims would usually give an indication that the consumption component of the economy, the biggest contributing factor to GDP, would remain sluggish, and that business earnings would likely face dire consequences.
Yet, the stock market soared during the time frame, creating further suspicion that investors were overpricing assets after any indications of remotely good news. For the less financially savvy individuals who own retirement accounts and other investment funds, the recent months can offer some well-established lessons for investing.
For one, it is important to remain consistent with your goals, especially for young people investing in the distant future. Short-term fluctuations are rather insignificant compared to where stock price levels will be decades from now. In fact, it could be smart to take advantage of periods where prices tend to fall by buying shares at discounted prices. Second, it might be healthy from a mental well-being standpoint to not pay much regard to investors’ projections of markets’ trajectory, especially in times of irrational exuberance.
Moreover, as unique as recent times have been, they are not extraordinarily unusual. Periods of large declines in stock prices, known to many as “Bear Markets”, have historically occurred every several years. It’s not abnormal for people who have worked years building up their wealth to watch as their investments lose so much value in so little time.
And yet, the markets have always recovered their lost value.
While many older workers and fresh retirees are more likely to have strong feelings of anxiety during volatile periods, younger people in the workforce should be more prepared to maintain emotions of patience and dedication during times that will inevitably become brighter.
One of the biggest costs of investing in stocks for long-run gains is being able to persevere through the most turbulent of times.
