The Stock Market Is Not the Economy

COVID-19 has damaged a lot of things, including the link between the S&P 500 and the U.S. economy.

The COVID-19 crisis, in addition to the tragic loss of life, has severely damaged many things, from our social interactions to global supply chains, from job prospects to entire health care systems.

It also appears to have damaged the link between the stock market and the real economy.

Dark Assessment

Even after a fresh tumble last week, the S&P 500 Index is still down less than 15% year-to-date. It was down twice as far in mid-March—and even that took us only to a level one might expect in a typical recession.

We only need to look around us to see this is not a typical recession. It shrank China’s economy, the world’s second-biggest and the engine of global growth, by almost 10% in the first quarter. It knocked 3.8% off of first-quarter GDP in the eurozone and 2% in the U.K.—before the worst effects of the global lockdown had been felt there. On Friday we learned that U.S. industrial production in April was down 15%, year-over-year, and retail sales were down 22%.

It has also destroyed 10 years’ worth of U.S. jobs growth in just two months—and that pain is not being shared equally. During a dark assessment of the economy last week, Federal Reserve Chairman Jerome Powell noted that 40% of households earning less than $40,000 a year had lost a job during March. The worst may be yet to come: Some economists think the U.S. unemployment rate may end up being 20 – 25% when the May numbers are reported.

The very worst may be over, however. Most European economies are slowly reopening, including those hit most by the virus. Twenty-nine U.S. states, representing some 40% of the U.S. economy, are now allowing at least some nonessential businesses to start up again. The focus is tentatively shifting onto how to save livelihoods as well as lives, an important shift in the policy debate.

Nonetheless, it’s increasingly clear that recovery is likely to be long, grinding and incomplete, and shine a harsh light on inequalities of income and access to health care and educational opportunities. At the very least, in the face of that struggle, society is likely to demand that a larger share of economic growth accrue to labor rather than capital. At worst, those growing inequalities threaten outright civil unrest.

How does all that fit with 2,800 for the S&P 500?

Huge Dispersion

In fact, it may not be as strange as it seems.

Some parts of the index—the most cyclical, economically sensitive parts—do look as battered as the economy itself. As of May 15, the financial sector is down more than 30% year-to-date, for example, and the autos sector is down more than 40%.

Those losses are obscured by the performance of other stocks that are not cyclical (think health care and consumer staples stocks), or that may be cyclical under normal circumstances, but are solving big problems for us right now (think technology and ecommerce stocks, including the giants that have driven the relatively better performance of the S&P 500).

Since the turn of the century, those defensive and growth-oriented technology and non-cyclical stocks have expanded to represent 70% of the S&P 500’s market capitalization. Analysts forecast a decline in their earnings of “only” 13% in the second quarter, as opposed to 71% for financials and cyclicals.

We can see this huge dispersion clearly in other stock indices.

The performance of the S&P 500 is driven by mega-caps, whereas around 45% of U.S. GDP is generated by small businesses employing fewer than 500 people. Unlike the S&P 500, the Russell 2000 Index of small and mid-caps is down close to 30% year-to-date. At the extremes, the large-cap Russell 1000 Growth Index is down less than 3% year-to-date versus a decline of almost 40% in the small-cap Russell 2000 Value Index, which is dominated by financial and cyclical stocks.

No Stock Index Is Completely Shielded

In short, the S&P 500 is not the economy. While it may look as though COVID-19 has somehow damaged the link between the two, that link was not very strong in the first place.

We should therefore not be surprised that the S&P 500 has been relatively resilient in the face of such horrendous economic data. But nor should we assume that the S&P 500 is immune to the virus. Over time, economic fundamentals converge with financial markets.

Our economic view remains that we are a long way from getting through this, and it will take time to recover the losses our economies have suffered. When even the most resilient companies face a double-digit decline in earnings over a single quarter, it shows that no stock index is completely shielded from an economic shock of this magnitude. As last week suggests, the ride for the S&P 500 will likely continue to be volatile.