Why stock markets are rising when the economy is in bad shape?
When news of COVID-19 affecting the whole world came out early this year, the stock market of all major economies reacted sharply, most of them tanked by 25–30% in a matter of just 2–3 weeks. The S&P 500 index, one of the most followed index in the world, tanked more than 32% in just 18 days. The crash of March 2020 was one of the most severe crashes, in the history of stock markets. Ironically, the meltdown felt quite obvious, as the governments across the world were putting unprecedented restrictions to curtail the spread of the disease. And it was going to impact all businesses alike. The economy had to take the titanic like ice-berg hit and was destined to sink.
However, since the starting of April the stock markets in all major economies have bounced back and had nearly covered a major part of the fall; S&P 500 index is back at ~3k levels from the lows of ~2.2k observed during the crash(refer graph 1). And all this happened, while we were continuously getting the bad news regarding an increase in COVID-19 cases, uncertainty of vaccine, fresh layoffs, record unemployment cases and companies closing down or trimming their operations.
Now, at this point, it is very confusing why the markets are traversing a path exactly opposite of the economy. Aren’t the market suppose to reflect the economy? is the global economy really in bad shape or not?
I have a viewpoint on this seemingly convoluted situation, which I believe explains the phenomenon being observed. However, I would like to state that I am not an expert and this might not fully convince you or it might seem absurd to you. (I am fine with all of the possibilities).
My explanation:
- The high range of expected outcomes for the economy (bad, worse, ugly, etc), even at this point(mid of June) in the COVID-19 crisis makes the entire situation highly uncertain.
- No one can surely forecast by when the crisis would be over.
The above two factor makes the current markets very uncertain and highly volatile.
Let’s understand the Demand & Supply play in the current situation:
Demand-side: Owning to fear and anxiety due to the uncertainty related to COVID-19, people won’t be ready (in the near future, period uncertain)to spend the available money. Therefore, demand is going to be depressed for an unknown period (any forecast on demand is most likely would be erroneous) until the uncertainty of the crisis looms over our heads. Specifically for discretionary goods. The extent of the drop in demand can be loosely be derived from the energy demand as energy is one of the consistent raw materials across industries and also reflects the household demand. As per the IEA report, the expected drop ~ 6%, which is seven times the drop experienced after the 2008 financial crisis.
Supply-side: With a decrease in the demand, suppliers have no option but to produce less. There is no point in producing the goods just for stocking up in warehouse or plant. Also, excess production can lead to a price drop for the goods. (eg-the oil price shock observed during the month of March)
So when all suppliers have to cut down the production, some companies, unfortunately, would go out of business.
In such a situation the bigger companies, who have excess to a relatively cheaper source of capital, higher possibility of government protection, and benefit of economies of scale would have an upper hand vis-a-vis to smaller players in the market.
Thereby, most of the burnt of the slow down/recession would be faced by the smaller players in the market.
So the answer to the question: Is the economy in bad shape? Sadly YES, the economy is in horrible shape due to the COVID-19 situation and might remain in shambles for a long period of time. The most notable parameter of economic health of country i.e. unemployment rate is at a record high in most of the countries.
Further, nearly all rating agencies and institutes are unanimously stating that we are going into a recession and this could be far worse than the 2008 recession. World bank in its most recent report (8th June 2020) has stated that it would be the worst recession since world war II. As per the report Global economy is expected to shrink by 5.2%. To counter the recession, there are many financial and monetary stimulus packaged declared by the government across the world. IMF predicts that these affirmative actions from the governments across the world can only lower the impact, but they simply can’t stop the upcoming recession.
I hope now there is no doubt over the extent of economic impact on world Economy by COVID-19 crisis.
Even now the question remains, why aren’t stock markets reflecting the economic crisis?
Before answering the question, first let us understand a market index: a weighted index that measures the performance of top traded companies. It mostly consists of top companies, for example, S&P 500 reflects the top 500 companies of the USA, CAC 40 of France consists of the top 40 French companies, FTSE 100 is top 100 companies of United Kingdom, Nikki 225 are top 225 companies of Japan.
Second, the market price of the listed companies reflect the expected future performance/or value of the company.
Now, when the smaller companies are going to face a tough time in the near future(6–12 months) and many might get closed during the next 1–2 years( reason stated above).
In the future(2–4 years horizon) bigger companies, which have high chances of survival, are going to replace smaller players and enjoy higher market share. And hence are likely to show improved financial performance in the long term.
The expected improvement in future financial performance results in a higher current valuation of the traded shares of the company.
Thus, an index that mostly consists of much bigger companies is on a rising trend and I believe this is the reason why markets or indexes are currently rising, even when the economy is in horrible shape.
Kindly share your thoughts on the topic.
Note: The above article is based on my research on the current situation in the stock markets. This is not a recommendation and thus should not be considered as an advice for your investment decisions.
