If the economy is hurting, why is the stock market climbing? Here’s one simple answer
There’s one call most financial advisors are getting these days — and maybe a call you made yourself.
“I was really pleased when I opened my second quarter account statement,” my client told me recently. “But I don’t understand how my account can be in positive territory when the economic news is so bad.”
People wonder how the stock markets can be climbing, even hitting new record highs, when the economic news is so dire.
The answer is easy: The stock market isn’t the economy. But that answer deserves a bit of explanation.
For one thing, the economy and the stock market are measured by different yardsticks.
The U.S. economy is measured by the gross domestic product, which measures the value of goods and services produced in the economy. The effect of COVID-19, both the human toll and the economic loss from forced business shutdowns, has been profoundly and historically negative.
On the other hand, the stock market measures the value of companies in the specific market it tracks. So, for example, the Standard & Poor’s 500 (S&P 500) tracks the value of 500 of the largest companies in the nation. By comparison, the Dow Jones Industrial Average tracks only 30 large companies. The NASDAQ Composite Index tracks more than 2,500 stocks.
The next logical question is, how can the value of companies in the stock market go up when the economy is in a recession, unemployment is high and corporate earnings have dropped?
A critical difference between the economy and the stock market is that the stock market is what’s known as a Leading Economic Indicator. It looks ahead at what the economy is expected to do rather than focusing on what’s happening now.
The stock market is well aware that economic news is bad now but it’s been boosted by expectations that a viable vaccine will be readily available in 2021, interest rates will remain low, Congress will pass another rescue package and the Federal Reserve will step in to provide any liquidity the economy needs.
This scenario would be very positive for company profits 4-6 months down the road, so the market moves higher.
This doesn’t mean the stock market won’t tumble on current or future news. Any news that could change this rosy outlook can have a negative effect on the market and the drop in value could be significant. It’s why many stock market prognosticators expect continued volatility.
One more point of note about this particular stock market run-up is that about 20% of the S&P 500 is made up of five tech stocks. It’s well known that technology companies have thrived in this pandemic because tech has made it easier for people to connect and for many businesses to continue operating.
All of this is why many financial advisors, myself included, recommend this plan of action:
▪ Consider setting aside cash for any major expense you expect in the next 1-2 years.
▪ Keep your portfolio diversified among different types of asset classes: stocks, bonds and cash. This is often referred to as not putting all your eggs in one basket.
▪ Review your risk tolerance. If you’re not sleeping at night because you fear being whipsawed by the stock market, it could be a sign you need a different portfolio. Alternatively, if you fear you might miss out on the next stock market rally, that could signal it’s time to review your portfolio, too.
▪ If you have a long-term investment perspective, it may be wise to sit tight and wait it out. But you might consider reviewing your portfolio to make sure it hasn’t shifted out of your preferred balance because of moves in the market.
History shows that this will pass, although some past economic challenges have been overcome more quickly than others. The resourcefulness of the most valuable U.S. asset — its citizens — has always persevered.
Barbara McMahon is a CERTIFIED FINANCIAL PLANNER professional and member of the Financial Planning Association of Greater Kansas City. She is the president of Innovest Financial Partners in Kansas City. Securities and Advisory Services offered through an Investment Advisor Representative of Cetera Advisors LLC, Member FINRA/SIPC, a broker dealer and Registered Investment Advisor. Innovest Financial Partners, Inc. is independent of Cetera Advisors LLC, 601 E. 63rd St., Suite 220, Kansas City, MO 64110, 816-363-6660.
This story was originally published August 31, 2020 at 11:21 AM.