Investing Insights - Quick Take

The Stock Market Does Not Reflect Economic Reality

Posted By: 3Summit Investment Management

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The S&P 500 returned 20.54% for the second quarter and has generated returns for the first two quarters of 2020 of 7.51%.  Nothing to see here, we have had a great year so far.

My apologies, I thought opening with some good news and a little dark humor might be a good idea because I do not have much in the way of good news regarding the economy. The dichotomy between the stock market and the economy has perhaps never been so glaring…and I mean never. There is no question that economic indicators are extremely bleak. The economic numbers are beyond the point of comparison with any recent recession and in most cases are only comparable historically to 1929.

Aside from how awful the economic numbers are, there are many differences between today and 1929. Not the least of which is how our monetary system functions and the fact we are not on the gold standard any longer. I really think comparing our economic situation today with 1929 is not terribly relevant, however the fact we have to go back to that time period to find similar numbers is not that comforting either. What is relevant is that economic and market risk is very high right now. Risk management is extremely important in these markets. The stock market is not the economy, but at some point they are likely to converge.

Here are some highlights of economic indicators that I believe are important and more representative of current economic conditions than the stock market is at this time.

  • Gross Domestic Product (GDP) – GDP measure the economic output of the economy. GDP declined -9.5% for the quarter, officially the largest decline since the government began tracking GDP. Obviously, we expected things to be bad because the economy had to be largely shut down in the second quarter, but there are reasons to believe a partially shutdown economy may persist for a year or more. Currently, the recession is twice as bad as the Great Recession in 2008.
  • Unemployment – Unemployment has never quadrupled, and certainly not overnight. The official unemployment rate reached almost 15% before recovering to 11%. However, unemployment claims are rising again. Also, unemployment offices in states around the country have been overwhelmed, many individuals have not yet been officially counted, meaning the real unemployment rate may be closer to 20%. One thing we know about unemployment in any recession is that many jobs never come back or come back slowly over years. There is no reason to believe this recession will be any different. Elevated unemployment rates may be will us for a decade.
  • Permanent Business Closures on the Rise – Yelp put together a great data set on the number of temporary versus permanent business closures. It is not surprising that permanent business closures are rising and there is no end in sight with this pandemic.
  • COVID-19 – The U.S. has not done well containing the virus, daily cases reported are much higher today than during the shutdown.

Source: The New York Times

I could keep going, but I will stop there and just emphasize that the economy and the stock market have diverged from each other to an epic degree. But why? There is no simple answer to this question. The most likely answer is that the U.S. Government has pulled out a triple barrel bazooka of economic stimulus. In just the first two months of this economic crisis the economic stimulus programs are three times as large as all the economic stimulus programs during the Great Recession!

Perhaps the reason the stock market and real economy have diverged so dramatically can be summarized in a single chart. The amount of direct payments and unemployment benefits have been so large that despite an economic collapse, real personal disposable income increased by 10% in the second quarter while GDP collapsed by -10% in the same quarter.

Never on record has the divergence between disposable income and GDP been so massive. For that matter, never on record has there ever been such a large change in disposable income or decline in GDP in a single quarter. The fact both records occurred in the same quarter is mind blowing really.

Honestly, I have never put a chart together that was as shocking as this one has been for me. What this chart clearly says to me is that direct government fiscal support has been so tremendous that individuals and families have been insulated from the economic realities we face…and so has the stock market.

The government has been subsidizing millions of salaries through the Paycheck Protection Program and forgivable loans, providing additional payments to the unemployed, sending $1,200 checks to individual taxpayers, providing grant money to small businesses, bailing out airlines and the list goes on. The scale of money injected into the economy and directly into individual and business bank accounts is so massive that a large percentage of the population is actually better off than they were at the end of 2019 when unemployment was around 3%.

The bottom line is that the level of government financial support just in the first two months of this crisis is incredibly expensive. The total amount so far is 12.1% of U.S. GDP. COVID-19 is not under control and this level of government spending is not sustainable over the longer term, so the longer the virus thrives the higher the probability becomes that the gap between the economy and the stock market will close. Risk management has never been more important than it is now for investors.

3Summit Investment Management, LLC is a registered investment adviser.  Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies.  Investments involve risk and, unless otherwise stated, are not guaranteed.  Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.

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