Bad news, good news

In 1982, the unemployment rate started high and finished higher. It entered the year at 8.6 per cent and concluded at 10.8 per cent, its steepest level since the Great Depression. That was the first time that I had paid attention to employment statistics, because I was approaching my college graduation, and I must confess I was worried. (Correctly, as it turned out: I would not land a permanent job until summer 1984.)

To my surprise, stocks surged in 1982. The S&P 500 gained 21.6 per cent on the year, well above its average. That made no sense to me. Not only was unemployment rising, but seasonally adjusted gross domestic product fell during every quarter of 1982. The media called it “the Reagan recession.” (It wasn’t until later that I realised presidents cause neither busts nor booms.)

What I did not know, because I was not then an investor, is that stock prices are only tenuously connected to general economic conditions. For one, stocks anticipate future developments rather than dwell on current affairs. For another, neither employment statistics nor GDP growth directly affect equity prices. The primary drivers are instead two sets of expectations: 1) future earnings and 2) future interest rates, with the latter being used to discount the former.

Disconnected

Later I learned that it is difficult to find even an indirect relationship between a country’s GDP growth rate and its future stock-market returns. In perhaps the most widely cited of such studies, London Business School professors Elroy Dimson, Paul Marsh, and Mike Staunton found a negative correlation between national per capita GDP growth and stock performances. (When aggregate GDP growth was substituted, the correlation became slightly positive.)

In theory, expansion floats corporate boats. In practice, many factors affect whether an economy’s general success reaches companies’ bottom lines. Managements may squander their good fortunes by making poor investment decisions. Workers may collect the gains instead, through wage inflation. Or governments may enjoy the benefits, through corruption or excessive taxes. The economy is not the stock market.

This year has powerfully reinforced that lesson. Unofficially, unemployment is currently far above 1982’s apex, although the official numbers are lower, as they do not count workers who have been sidelined but who expect to return to their positions. At negative 4.8 per cent, the first quarter’s GDP slide was deeper than any suffered in 1982, and of course that was only the beginning. The second quarter’s GDP decline is forecast to approach 30 per cent.

Yet stocks have rallied strongly, even as the economic news has deteriorated. (When stock prices began to rise in late March, the consensus second-quarter GDP outlook was for an 18 per cent decrease. Since then, stock prices have steadily climbed, while the GDP predictions have steadily fallen.)

The few and the many

To be sure, the headlines do not relate the full story. The S&P 500 has recovered so powerfully as to make its year-to-date loss of 12 per cent unmemorable, aside from the abruptness of the path. Meanwhile, small-company indexes have fallen twice that far, and small-value indexes, which represent the largest number of publicly traded companies, are down 30 per cent. Those are genuinely poor results.

Nonetheless, as large companies account for about 80 per cent of U.S. stock-market capitalization, their performance reflects most investors’ experiences. And those experiences have been benign compared with the awful showing of the overall economy. Two additional factors have weakened the already tenuous link. One is the increasing divergence between the “have” companies and the “have nots.” The other has been the federal government’s aggressive intervention.

While most businesses are at best struggling, a happy few are booming. This fact is not only reflected in the performance gap between the large- and small-company indexes, but also by the disparity in fortunes between public and private companies. Because publicly traded firms operate nationally (if not internationally), they tend to be technologically capable and therefore positioned to compete during social distancing. Local businesses, in contrast, are likelier to be brick-and-mortar affairs that are hampered by movement restrictions.

In other words, that millions of workers have been released by local businesses--or national firms in industries that have been devastated, such as airlines and hotels--is relatively immaterial to the stock market’s leaders. As long the layoffs don’t lead to a ripple effect, wherein the broader economic woes affect their revenues, their stocks quite logically can rise even as other businesses fall.

Once again, the Fed put

This much I knew six weeks ago. What I did not realise was that, at least to date, the ripple effect would not occur. One reason has been banks’ relative health, which has forestalled the financial panic that bedeviled 2008’s stock market. Happy banks do not always make for happy stock prices, but unhappy ones inevitably lead to misery. However, the other explanation lies not with the marketplace but instead with its overseers: The federal government has been a most generous host.

Both the Federal Reserve and Congress, through the CARES bill, have rained money onto the economy. Such actions have helped preserve consumer spending power. In addition, they have encouraged equity investors by demonstrating that both major parties--there has been little disagreement on either side of the aisle--will spend what they believe is needed to maintain some semblance of normality.

Government intervention is the new and updated version of “The Fed Put”: the idea that the Federal Reserve could always support equity prices, whenever it desired, by cutting short-term interest rates. Those rates are currently at zero, so that game can no longer be played. But the Federal Reserve can continue its newer technique of buying bonds in the open marketplace and flooding the banks with liquidity, and Congress can pass new stimulus bills. It likely will.

Whether such activity will benefit investors more than workers remains to be seen. Thus far, it has.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.