Investors have been watching the disconnect between stock prices and the economy as stocks have continued to rise despite the worst economic downturn since the Great Depression. Although this is not a new phenomenon, it is interesting given the magnitude of the present economic slump. Here are some key reasons for a downturn in stocks as well as reasons why they could move higher.
The Link Between Stocks and the Economy
I remember reading about a study from Goldman Sachs GS -1.4% several years ago which examined the relationship between stock performance and economic activity. It concluded that about 40% of stock price movements were attributable to economic activity. That may explain part of the disconnect but there are other, more important factors to consider.
10 Year U.S. Treasury Yield
Alan Greenspan once remarked that if he could only view one indicator to gain a sense of the health of the economy, it was the yield on the 10-Year Treasury. Why? In general, when net buying pressure exceeds net selling pressure, price rises. Whenever there is strong demand for U.S. Treasuries, their price rises and yield falls. Since U.S. Treasuries are considered the safest investments on earth, whenever yields fall (price rises), buying pressure is greater than selling pressure. The reason for this is often rooted in fear. When investors get nervous, they tend to sell risky assets and seek safety. Where is the yield now?
At this moment, the 10-Year Treasury is yielding 0.577%, which is very close to its all-time closing low of 0.54% on March 9, 2020. This bellwether yield is a good indicator of what we already know, that is, that the U.S. economy is struggling, and fear is rising.
Gold & Silver
Gold and silver are another good metric to watch. When fear rises and investors seek cover, more money flows into gold and silver. Currently, silver is at a seven-year high and gold is near an all-time high.
Another good indicator is the valuation of the U.S. stock market. In short, is it under- or over-valued? One ratio compares the total market capitalization of all U.S. publicly traded stocks to total GDP. Since GDP measures total economic output, this ratio is widely used to gauge the valuation of the U.S. stock market. Be aware that stocks can remain over- or under-valued for an extended period. In short, it is useful when used in conjunction with other data. Where are we now?
Currently, the ratio indicates that stocks are 55.3% overvalued. For perspective, the all-time high was 58.9% overvalued, which occurred February 19, 2020.
The Coronavirus Effect
The primary cause of our anxiety today is Covid-19. The George Floyd incident is another, but without this virus, it’s possible that police officers would’ve been less stressed, and the entire incident might never have occurred. The emotional upheaval from this virus is clear and emotions have a tremendous influence on behavior. This behavior can be found in the debate over how to eliminate this virus. Many, whether intentional or not, have helped fuel this divisiveness. It doesn’t help when our leaders can’t agree.
President Trump was initially against wearing masks to stem the outbreak, despite strong evidence that masks help. Many adopted his view and fought just as vigorously against the policy. Fortunately, he has reversed his position and now supports wearing masks. Recent polls show that 75% of Americans support a mask mandate. Now for the bullish case.
The Bullish Case for Stocks: Liquidity, Liquidity, Liquidity
Earlier this year, when it seemed the credit markets might freeze, the Fed announced its intent to purchase any securities necessary to keep markets from collapsing. What caught my attention was its intent to purchase the bonds of companies with a weak credit rating, referred to as junk bonds. Why? Failure to buy this debt would’ve resulted in more selling pressure which would have caused prices on these securities to plunge, which would’ve created a ripple effect. Even though the fed did not actually purchase these securities at that time, the reassurance instilled confidence in investors.
Another key was the federal government’s relief package, which helped keep unemployment from spiking further. It also put money in the hands of the public, which helped fuel online sales (consumer spending). Washington is now working on a second stimulus bill to provide additional support for the economy.
Since we have never witnessed actions of this magnitude from our government, it’s hard to know if it will be effective. Even if the next round of stimulus is successful and stocks move higher, it could create the next stock bubble, especially with stocks being so over-valued.
Will this stock market rally continue unabated or will we see a correction soon? If this virus lingers another year or more, to avoid a more serious problem, the government will need to inject a great deal more liquidity than the estimated $1.0 to $3.4 trillion dollars expected in the next relief package. When I consider all aspects surrounding Covid-19, many of which I did not mention (ex: vaccine, willingness to abide by recommended safety measures, etc.), and the effect on the economy and financial markets, plus the emotional toll imprinted on the psyche of individuals, it’s hard to envision a quick recovery.
The emotional effects of this will linger for a long time, which will impact the economy and financial markets. What will change? Businesses will seek to become leaner in preparation for the next great challenge and individuals will likely save more and spend less. Whenever something of this magnitude occurs, we tend to examine our situation and seek ways to protect ourselves in the future. It’s just another way of coping with a crisis.