Why Haven’t Stocks Crashed During The Economic Freeze?
June 04, 2020

Why Haven’t Stocks Crashed During The Economic Freeze?

Unemployment is at a record level. Restaurants, retail services, airlines and social facilities are either frozen or moving with glacier-like creep. Plenty of business owners fear their companies won’t survive.

This might have you wondering, “Why haven’t stocks melted in this mess?” Between January 1st and June 4th, 2020, the S&P 500 is down just 2.5 percent. A Couch Potato portfolio invested 50 percent in U.S. stocks and 50 percent in U.S. bonds is up 3.8 percent.

If you’re a keen follower of business news, this might not make sense. You might think stocks should have crashed as business earnings shriveled. You might think bonds should have crashed as the government increased debt. Here’s why this hasn’t happened.

The stock market is not the economy. And the economy is not the stock market.

I know. This doesn’t jibe with what you might see on T.V. But the financial media’s job isn’t to educate investors. It aims to scare and excite them. It aims to make you think people can predict stock market movements based on what the economy is doing. But that simply isn’t true.

The stock market and the economy are a lot like cousins. They’re genetically related, but they aren’t the same. You might have a cousin who can run 100 meters in less than 11.5 seconds. She’s aiming for the Olympic team. But that doesn’t mean you’re fast. The economy and the stock market are just as disconnected.

Consider China. It might be the fastest growing economy in the world. Its GDP growth runs circles around U.S. GDP growth. In a single generation, China’s cities morphed from third-world developments to futuristic realms. They make America’s most modern cities look old, in comparison. The numbers of Chinese billionaires have grown faster than bamboo in a Borneo jungle.

Despite a glowing GDP, since 1993, when the Chinese stock market opened to public foreign traders, the country’s returns have been pathetic. Below, I’ve shown the past ten years, compared to the U.S. market.

Economic Growth Relates Little To Stock Market Growth
January 2010 – April 30, 2020

Graph of Chinese vs U.S. Stock

In 2012, the University of Florida professor of finance, Jay R. Ritter published “Is Economic Growth Good for Investors?” He found that the fastest growing economies, as measured by GDP, didn’t record strong stock market gains. In fact, after measuring the returns of 15 emerging market economies, he found their stock markets lagged those of slower growing economies.

The stock market is not the economy. And the economy is not the stock market.

This applies to the United States as well. On August 22, 2019, I published “Should Investors Fear The Inverted Yield Curve?” Historically, when the yield on a 2-year government bond exceeds the yield on a 10-year government bond, it usually signals a recession. That’s like your cousin twisting her ankle. She’s now on crunches, so she can’t run. But that doesn’t mean you can’t run, unless you fell in the same ditch after a few too many drinks together.

Between 1973 and 2006, six inverted bond yield curves occurred, based on Richard G. Anderson’ article, Yield Curve Inversions and Cyclical Peaks for The Federal Reserve Bank’s Economic Synopsis. Recessions did follow. But the economy isn’t the stock market. And the stock market isn’t the economy.

One year after the bond yields inverted (coinciding with upcoming recessions) U.S. stocks gained an average of 5.27 percent. Five years after bond yields inverted, U.S. stocks gained an average of 9.46 percent per year. Ten years later, they recorded compound annual gains of 12.0 percent. Twenty years later, they averaged compound annual returns of 12.01 percent. Unfortunately, those who decided not to invest (or not to stay invested) based on economic data would have missed some big gains.

The stock market is not the economy. And the economy is not the stock market.

Some people worry about unemployment figures. Imagine if somebody had a working crystal ball. Six months before unemployment numbers hit a peak, they whispered future unemployment figures in your ear. Would you have sold your investments?

Below, I’ve listed 14 dates representing 6 months before unemployment figures peaked. Overall, stocks didn’t fall…they rose strongly instead.

Do Unemployment Numbers Predict A Stock Market Drop?

Six Months Before Unemployment Peaks S&P 500 Returns
12 Months Later
November 30, 1932 +57.7%
December 31, 1937 +33.2%
July 30, 1946 -3.4%
April 30, 1949 +31.3%
March 31, 1954 +42.3%
January 31, 1958 +37.9%
November 30, 1960 +32.3%
February 26, 1971 +13.6%
November 29, 1974 +36.2%
January 31, 1980 +19.5%
June 30, 1982 +61.2%
December 31, 1991 +7.6%
December 31, 2002 +28.7%
April 30, 2009 +38.8%

Some people worry about future bond prices, based on the money the government is giving away. Such freebies will increase government debt. Will bond prices fall? Nobody knows for sure. But bond markets and economies aren’t closely related either.

Japan’s scorching debt was reported to be 238 percent of its GDP at the end of 2018. The country is still reeling from the Asian economic crisis of 1997. By comparison, U.S. government debt was about 109 percent of GDP in 2019. In other words, the U.S. debt level is high, but it isn’t close to Japan’s.

However, according to PWL Capital’s Benjamin Felix , Japanese government bonds have averaged about 5.83 percent per year since 1990, when hedged to the USD. That’s a surprisingly strong return, despite the country’s debt.

The bond market is not the economy. And the economy is not the bond market.

If the two were closely connected, government bond prices would be falling as countries take on increasing amounts of debt during COVID-19. But that hasn’t happened. Bond prices are up.

Public expectations affect stock and bond price movements far more than the economy. Consider China’s stock market. Public expectations are high. But if we expect, for example, China’s GDP to increase 10 percent, and it increases by 8 percent, this disappoints investors who then might sell.*

It’s much the same with individual stock earnings. If we expect a business’ earnings to rise 20 percent, and earnings rise by 15 percent, this disappoints investors. More often than not, investors will sell, dropping the stock’s price. On the flipside, if we expect earnings to be 15 percent, and the actual earnings increase by 20 percent, this makes investors happy. As a result, more people will buy and that drives the price up.

Now let’s circle back to the economy. If we expect high unemployment, then news of high unemployment won’t surprise us. If we know that many businesses are closed, then we know their earnings will be low. If they end up higher than expected, it could drive stocks up. If they end up lower than we expect, it can drive stocks down.

Over short periods of time, the economy doesn’t drive stock prices.

People’s expectations play a much bigger role.

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This article contains the opinions of the author but not necessarily the opinions of AssetBuilder Inc. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.

Performance data shown represents past performance. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown.

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