Why Is The Stock Market Doing So Well In The Face Of So Much Poor Economic News?

Unemployment, lower projected profits, pandemic woes–despite all this news, Kevin Grogan explains why the market is doing well–and provides perspective on how to think about market movement.

Transcript

Tim Maurer:
Hello, Tim Maurer back with another episode of Ask Buckingham, a new video podcast designed to bring clarity in the midst of confusion by connecting your great, personal finance questions with straightforward answers from industry thought leaders.

Tim Maurer:
Today’s question will be answered by Kevin Grogan, managing director of investment strategy for Buckingham Wealth Partners.

Tim Maurer:
And Kevin, why in the world is the stock market doing so reasonably well during the COVID-19 pandemic, while the success of so many small and large businesses, in many sectors, seem to be doing so very poorly or even shutting down entirely? How is this possible?

Kevin Grogan:
Yeah, so to put a timestamp on when we’re recording this, because you never know what the stock market will do over the next days and weeks. So we’re talking here in late July, and you’re right we absolutely have seen a pretty remarkable recovery for stocks.

Kevin Grogan:
We’ve seen the S&P 500 is now actually in positive territory year-to-date which is pretty remarkable even relative to a month ago that stocks have performed really well. And that is confusing given that I’d say over the last four weeks or so, the economic news hasn’t been all that great. It seems like the recovery is somewhat stalling out or it seems like it’s going to take a bit longer than it might have looked like, again, four to six weeks ago.

Kevin Grogan:
So I really want to hit on three different reasons for this. I think they all contribute to why we’re seeing the stock market do so well in the face of such poor economic news. And so the first point is what the stock market actually represents. So, the stock market reflects the future profits of the companies on the publicly traded stock exchange.

Tim Maurer:
Okay.

Kevin Grogan:
And so that’s really the first thing to understand is that the market is reflecting expectations about the future and is not necessarily as focused in on what’s happening in the here and now. So like I mentioned, I think the last four weeks or so you would say that most market participants are expecting lower profits for companies here in 2020 relative to what they might have been expecting four weeks ago.

Kevin Grogan:
And now, on the flip side over the last four weeks, we’ve had lots of good news on the science front in terms of treatments and in terms of potential vaccines. So I’d say if you’re trying to project out profits a year from now, two years from now, three years from now, you’d say things are looking better now than they were four to six weeks ago. So I think that first aspect of it is huge is that the market is pricing in expectations about the future and is not backward looking. So that-

Tim Maurer:
Right.

Kevin Grogan:
I think is the first thing to understand.

Kevin Grogan:
And then the second aspect, it’s baked into the question is that when people say the stock market is doing well, that really only refers to U.S. Large-Cap stocks. So yes, U.S. Large-Cap stocks have done well and have recovered back into positive territory year-to-date. But that’s not true for smaller companies in the U.S. and that’s not true for international companies, either developed markets or emerging markets. So it isn’t a universal story to say the stock market is doing well. It’s only true for a portion of the market, something that might represent, call it less than half of the world market capitalization. So-

Tim Maurer:
But Kevin, in addition to that, what percentage of that, that appears to be doing reasonably well, is driven by just a handful of big technology stocks that seem to be doing well?

Kevin Grogan:
That’s a huge aspect of it as well, particularly over the past four to six weeks or so. It’s really been driven by technology companies in the Large-Cap space. So certainly you’re not seeing airline companies recover back to where they were, retail companies recover back to where they were, some of them are going away altogether. So it isn’t a story where the entire economy is healthy. It’s a handful of companies really driving that Large-Cap performance. And again, the Large-Cap performance isn’t knocking the socks off of a normal year.

Tim Maurer:
Right.

Kevin Grogan:
It’s just that the fact that it’s above zero, I think is surprising to a lot of people given the economic news so far.

Kevin Grogan:
And then the third thing I had mentioned is just the continued story with interest rates, so interest rates have continued to decline. So to close out last year, the yield on a 10 Year Treasury was right around 1.9%. That’s now down below 0.7%, actually getting closer to 0.6%. So if you think about expected returns on fixed income, they are now much lower than where they were to start the year. And when that happens, people respond to that. They say, “Look, I can’t meet my goals investing in fixed income so I have to invest somewhere. So I’m going to go into real estate. I’m going to go into stocks” or certainly a part of them. And that’s likely driven some of the increases in stock prices that we’ve seen here recently.

Kevin Grogan:
But the main, that sort of takeaway I would have from these three items that I don’t view where the stock market today is irrational. I don’t necessarily view it as a bubble or anything along those lines. But there are good explanations for what we are seeing.

Kevin Grogan:
Now with all of that said, if you looked at those tech companies in particular, or even just U.S. Large-Cap stocks in general, the price-to-earnings ratio, then you’re paying for a dollar of earnings on those companies is much higher than what you would have a year ago, or certainly five or six years, or 10 years ago, you’re paying more for dollar earnings today than you were. Which all else being equal, we would say would lead to lower, forward looking, expected returns on those assets than other assets like international stocks or Small-Cap stocks.

Tim Maurer:
So in general, if I’m hearing you correctly, the market is a forward leading indicator of sorts. It’s looking out into the future, all the while it doesn’t tell us exactly how far into the future it’s looking. It probably changes from time to time based on any number of circumstances. Right?

Kevin Grogan:
Absolutely. So one thing I’ve mentioned in the past is the stock market is the closest thing we have to a time machine, in terms of seeing out where things will be a year from now, and then it’s not always right, obviously. The market wasn’t forecasting a COVID pandemic a year ago. I don’t think anyone really was if you were on the clock 12 months ago. But again, the market started declining in mid-February before we even had much in the way of cases, documented cases, much in the way documented cases here in the U.S.

Kevin Grogan:
And so the market is always looking out ahead over the next one, three, five years, and trying to price in where profits will be over that period of time and it’s always updating that on a minute-by-minute basis.

Tim Maurer:
Yeah, so the market is a forward looking indicator and there are elements of good news out there that are coming to the fore that might not be dominating the headlines quite so much as the bad news, but that’s being taken into account. But lastly, Kevin, one of those negative factors that has an impact, especially if you are one suffering from this challenge, is unemployment. I mean with unemployment at the rate it is, do all these same factors apply to why the market could be looking past that apparent massive indicator?

Kevin Grogan:
Yes. I think the market has priced in persistently bad unemployment for the rest of this year. It’s just that the market is saying, “okay, if we get,” and I’m just making this out, not making any forecasts on the science front. But I think if you were to rewind the clock three months ago and say, “what’s the best case scenario for developments in terms of the treatments and vaccines?” I don’t think you could have asked for anything better than what we’ve seen in terms of having multiple, viable candidates for vaccines looking like they might be ready to go by the first quarter next year. And possibly really good treatments by the fourth quarter this year, such that if you happen to catch the Coronavirus, you will have a better likelihood of recovering. We’re actually already seeing that to some degree, as we’re not seeing the death rates as high as they were.

Kevin Grogan:
And all of these things together coalesce around an expectation, in terms of the market’s point of view, that things might start getting better in let’s say the middle of next year, and might be all the way back in a year and a half from now, or some, some timeline along those lines.

Kevin Grogan:
I don’t think anyone thinks that the day after we have an approved vaccine, everything will be better because there’s still the challenges of manufacturing the vaccine, delivering the vaccine and convincing people to take the vaccine. So it’s not as if this will all be solved immediately, but I think the market is predicting and forecasting out that things will get better at some point. And that wasn’t a given, even as recently as three months ago, it wasn’t a given that we would find a vaccine. And now I think the market is saying, “okay, we’ve got multiple, viable candidates. One or two of those is likely to come through at some point over the next six to 12 months. And then things will start to improve from there.”

Tim Maurer:
Yeah. Well, Kevin, indeed we do hope that the market is right on this one, don’t we? That there is enough good news out on that front that we can see this from a positive perspective both looking through the investment lens but through the human lens as well.

Tim Maurer:
Thank you so much, Kevin. And thank you for tuning into this episode of Ask Buckingham. If you have a question that you would like to see us address, you can do so by navigating to the website, askbuckingham.com, or by emailing your question to question@askbuckingham.com, or just click in the upper corner of the screen, it’ll take you directly to the website.

Tim Maurer:
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