The Relationship Between the Markets and the Economy

In unprecedented times, it’s not uncommon for the stock market to move one way while the broader economy shifts another. Such is the case in the wake of the 2020 health crisis. The stock market soared in the wake of the pandemic – while the societal shutdown led to a full-blown recession. Scientific and public health debates aside, it’s enough to make you ask, “Just what the hell is going on?”

A Brief Look at the Pandemic Market vs the Economy

It’s important to note first that the intensity of the market crash and subsequent recession have not been seen in almost 100 years. In April 2020 alone, over 20 million people lost their jobs, were furloughed, or went on “temporary leave,” only to learn their jobs didn’t exist when stay-at-home orders lifted. Unemployment hit a record-breaking 14.7%, the highest number seen since the Great Depression.

And yet, in the same month, the S&P 500 index showed skyrocketing numbers – the best in three decades, in fact. At the time, the index was down only 9% for the year, representative of a correction rather than a full-blown bear market. In fact, in the 50 days after March 23 (the lowest point of the market crash), the S&P climbed 40%.

At the start of the third quarter of 2020, although the market occasionally shuddered, many indexes, such as the Dow Jones and S&P 500, held steady or showed incremental gains. In the case of the Nasdaq, technology stocks outpaced the market continually as demand for remote work and entertainment showed no signs of slacking off.

Despite rumors of shutdown rollbacks and renewed stay-at-home orders, as well as uncertainties in the country’s educational institutions, the market didn’t repeat the tumble it took in March. Part of the credit due goes to the Federal Reserve, which poured trillions into the economy and markets alike to keep confidence high.

And yet – the pandemic economy remained. Stores closed, reopened, and closed again. Mask orders went in and out of effect. States took turns breeding the next pandemic hotspot as some individuals returned to work, only to return back home to their quarantine lives. People still lost their jobs or their companies cut their hours and slashes their pay on an unprecedented scale.

This all begs the question: Why? Why did the economy go so far south when the markets climbed higher than Everest?

The Relationship Between the Markets and the Economy

The answer lies in the complex relationship between the market and the economy, as well as the inherent nature of human beings.

Simply put, the market and the economy are inextricably linked. In many ways, they rely on each other to forward the economic progress of our country – but they can, and do, perform in opposite directions under the right circumstances. Covid-19 provided the perfect storm for a modern-day, real-world example.

The Market Will Always Perform – Eventually

The economy, as a broad definition, is the system of supply and demand for goods and services within a specified region (state, national, global, etc.). On the other hand, when we refer to “the markets,” we are typically talking about one market in particular: the stock market.

In simple terms, the stock market is an exchange where companies sell “ownership” in a company in exchange for financial compensation. In return, shareholders may receive dividends (interest payments), voting rights, or just a chance to make a profit off the company’s good fortune.

So, in other words, the economy is the network of goods and services flowing throughout a given region. The markets, however, are where investors place bets and purchase ownership into the companies providing these goods and services.

In many ways, explaining market performance is easier than explaining the economy at large. Markets are not necessarily reflections of the industries they represent, but rather a reflection of how investors feel about their investments. The stock market especially, but all investable markets, run on mass sentiment and optimism, rather than a firm reality.

This means that, in the end, markets have no choice but to march forward. This is evident in the saying, “The market will always perform – eventually.” A firmly rooted belief that good times are ahead, even in the midst of the worst recession since the Great Depression, is exactly the reason that the markets will always perform (eventually). Quite simply, investor optimism, fueled by cycling news events and corporate practices, ensure that the overall markets will rise from the ashes and skyrocket anew.

This isn’t to say that individual stocks will always perform, or that a particular company will always do well. It’s just to say that the market as a whole will succeed in due time.

The Correlation Between Markets and Economic Performance

Part of why so many individuals (understandably) believe that the markets and the economy are the same thing is a product of our history. Our comprehension of the stock market, from historical trends to its current state, guides our view on the economy – and much of the time, there is financial evidence to support this theory. For many, the stock market is a metric, or perhaps a proxy, for how the economy at large performs.

For instance, the vast majority of the time, when stock prices are continually rising, the economy is doing well right alongside them. When stocks plunge, it’s frequently in tandem with the economy tanking. When the market trembles like a leaf, news cycles threaten the edge of a nationwide economic recession. But, when the market regains its confidence, all thoughts of economic sluggishness take a backburner to the hopes of brighter days.

The correlations are there the vast majority of the time – until a recession hits, and the market still performs. When you see the numbers side by side, it’s easy to see why people believe the markets and economy must be the same thing. In fact, many have touted this correlation as fact as far back as the Great Depression.

A Product of History

Between 1929 and 1932, the S&P tumbled 86% before it finally bottomed out. At the same time, the economy tanked. Millions lost their jobs, people were starving, and Hoovervilles popped up from coast to coast.

At the time, most individuals in the United States didn’t have access to the financial information companies and the government are required to share today. As a result of poor financial intelligence and a lack of transparency, many believed – not incorrectly so – that the stock market collapse was at least partially responsible for the Great Depression.

And thus, the first link. This relationship has remained firmly fixed in the minds of most investors ever since, and it’s easy to see why. (However, it’s worth noting that while the Great Depression was caused in part by the stock market crash of 1929, the root cause of the market crash was largely massive debt and market gambles on the part of everyday Americans – not anything that the market itself did unduly.)

So, why is the market dancing with the stars while our economy takes a journey to the center of the earth?

The Makeup of the Markets Vs the Economy

To understand the issue more completely, we’re going to dive into the makeup of the stock market as a subset of the whole economy. This reveals a much more complex relationship of economic transactions than a surface glance can provide.

Let’s start with a well-known entity: The S&P 500 index.

The companies that make up the S&P 500 are massive corporations. They function on vastly different principles than small businesses, individual workers, and even the cities and states that make up much of the economic web.

These giant companies hold massive liquid reserves – and/or billions in assets that could be liquidated if need be. And they maintain a firm grasp on both the stocks and bonds markets. Furthermore, almost 40% of their revenue flows from outside our federal borders. Meanwhile, the average individual or even small business may never interact beyond the borders of their own state.

In 2015, 600,000 companies within the United States employed a minimum of 20 individuals. Only 3,600 of which (less than 1%) listed publicly on a stock exchange. And yet, this 1% of companies comprises a massively disproportionate percentage of the gains made in the stock market. Their share prices alone are enough to skew the market data in such a way that the markets improperly reflect the overlying economy.

Market indexes such as these are a big factor in revisioning the economy with the markets. You don’t have to look any further than the S&P 500 for an example. The S&P 500 is weighted solely toward companies with deep pockets and deeper influences. And, yet, it’s commonly used as an indicator of economic health. During the pandemic market of 2020, corporate America – not the Mom and Pop shop down the street – took a drastically positive turn in the market, and thus slanted data across the economic board.

A Real World Example

Let’s take a look at a real-world example to explain how this works.

The five largest listed companies in the S&P were worth $1 trillion at the end of April. Alphabet (Google), Amazon, Apple, Facebook, and Microsoft – accounted for 20% of the market value of the index. At the same time, they each sat roughly 10% up for the year.

The other 495 companies in the S&P 500? Down 13% across the board.

It’s also important to note that these companies have several things in common. Like huge revenues and customer bases that require their services whether or not there’s a pandemic. However, the most important factor: they’re all based online or in technology. Even Amazon, essentially a major distribution hub, has an enormous online and marketing presence.

These companies were near-guaranteed to turn a profit in the event of a country-wide shutdown. Even regardless of the specifics of the disaster. Their profits – and soaring stock prices with them – had no choice but to skew the markets in a positive direction.

Markets in the Hands of the Wealthy

Many day-to-day investors make a tidy profit in the market. But another essential component of the stock market is that it’s where the rich go to gamble. Almost half of all households in the United States own shares in some sort of investment vehicle. But these accounts are typically modest. Even a full retirement savings account is usually worth, at most, a few hundred thousand dollars.

Most stock ownership lies in the hands of the wealthy. These are the people who can afford to buy stocks casually and eat their losses to a greater extent. This group is also statistically less likely to be seriously impacted by an economic recession. The Federal Reserve shows that the top 10% of wealthy households own 84% of all household stocks by value. Furthermore, the top 1% hold 40% of stock ownership alone.

As a result of the wealth concentration and its results on market performance, many economists agree on one thing. Over time, economic growth has little impact on the market, and vice versa. Rather, they are separate metrics that often happen to convey the same information. When the metrics differ in their presentation, therefore, they show two different pictures based on two different foundations. But it takes a massive event (a pandemic market) to draw out those differences for the public to see.

Let’s Talk Unemployment and GDP

We’ve covered the markets side of this debate. So let’s cover two of the most important economic aspects: unemployment and GDP.

As we mentioned earlier, in April 2020, 20 million people lost their jobs or were furloughed into uncertainty. This stacked the unemployment rate to an astonishing 14.7%. (As a reminder, that’s one of the highest unemployment rates since the Great Depression).

It’s important to note that, as a country, we have a not-unfair expectation of unemployment. That it’s a temporary predicament and typically lasts no longer than 6 months at a time. This assumption is so common that it’s enshrined in our unemployment laws. Until the passing of the CARES Act, individuals could only collect unemployment for 26 weeks. That was regardless of hardships or the economic situation. The CARES Act extended this timeframe to 39 weeks to account in the face of nationwide unexpected, extenuating circumstances.

Overall, this law assumes that while some will struggle, employment is always just an interview away for most. However, that’s not always the case. Depending on city and state circumstances, as well as the employee’s job-loss conditions, new work isn’t always possible to find.

The continually high unemployment rate is one reason the economy stayed depressed in 2020’s third quarter, even as markets soared. That, combined with individuals fearing for their safety amidst rising coronavirus concerns. Rich people had the ability to purchase and sell securities at their leisure. Meanwhile, the average American – employed or not – couldn’t afford the luxury of saving for their future.

A Quick Word on GDP

Another indicator of economic health is GDP, or gross domestic product. While this doesn’t have as strong an impact on the economy under some circumstances, it can in others. During the pandemic crisis, GDP straddled the line.

According to the BEA (Bureau of Economic Analysis), throughout 2020, only 10% of the United States GDP was determined to come from industries at a risk for pandemic-related losses. As a result, most believed it safe to assume GDP wouldn’t provoke an economic collapse. But it was enough to keep concerns circulating about the state of certain sectors.

What’s the Point?

The point is this: The economy and the markets are not by definition the same. But they are inextricably linked to a point that they affect one another in most circumstances. However, with the right conditions, it’s possible for the markets to move one way, while the economy moves the opposite. In the case of coronavirus, that’s exactly what the nation saw.

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