Why Is The Stock Market Up When The Economy Is Down

Looking at the stock market these days, with the S&P 500 up almost 30%  from its March 23 bear market lows, COVID-19 appears to be not much more than a short-term disruption. The economy, however, tells a far different story: with projections of a 40% contraction in the second quarter on an annualized basis and unemployment surging to 20%…

Clearly, two different narratives are being told by the stock market and the economy. The question becomes: which one is accurate?

A Dismal Economic Picture

The current economic picture is nothing short of alarming. Even though massive government interventions will likely prevent another Great Depression, a recession is a foregone conclusion.

A world of hurt for small businesses: The pandemic is causing severe distress for small businesses. The small business loan program meant to help smaller enterprises affected by the lockdown has run into a lag in response and repeated funding problems, and there are criticisms large businesses benefited, instead.

Large firms are not immune:  Larger companies in hard-hit industries such as airlines, retail, energy, and automotive are facing mounting pressures, and observers say bankruptcies among big names are possible.

Consumer loan defaults on the rise: With unemployment rising around the globe, many will be unable to pay their debts, resulting in consumer loan defaults.

Congressional Budget Office (CBO) paints a bleak picture—then a rebound: CBO’s latest estimates for the second quarter show a dramatic contraction in the economy. Its latest estimates also show economic activity is likely to increase in the third quarter, “as concerns about the pandemic diminish and state and local governments ease stay-at-home orders, bans on public gatherings, and other measures restraining economic activity.” U.S. Treasury Secretary Steven Mnuchin echoed the projection for a rebound in demand in the third quarter. CBO, however, has also cautioned that challenges will likely linger in both employment and economic activity. Moreover, any positive economic growth in the third quarter will be from a very low GDP figure.

Behavioral Biases May Propel Stock Market

During this COVID-19 pandemic, the economy is suffering severely, at least in the near-term; therefore, the stock market’s resilience seems illogical. One reason for the resilience may be investors’ behavioral biases, which are leaning decidedly bullish. When investors are overly confident about the future, they tend to look for evidence that affirm that bias, such as economies reopening and vaccine progress.

Behavioral biases likely played a role in the stock market hitting its all-time high on Feb. 19, 2020, with the S&P 500 closing at 3386.15, while the Nasdaq Composite neared 9,900 and the Dow approached 29,400. At the time, both the White House and many market observers were focused on encouraging signs that the virus outbreak would be contained. When asked in late January by CNBC about worries regarding a pandemic, President Trump said, “We have it totally under control.”

Since then, according to the latest data, more than 55,000 people in the U.S. have died from COVID-19, accounting for a quarter of the COVID-19 deaths worldwide.

The current market’s overconfidence seems to be driven by the Federal Reserve’s widespread interventions. The breadth of the Fed actions is unprecedented, including lending programs and asset purchases to boost equities when government bond yields are near zero, as well as fiscal policies to help American workers and loan programs for large and small businesses.

Another factor is the desire among investors to take on risk. With yields low at the moment, there is little incentive for fixed income investments. Instead, investors are putting more money into the stock market, even though that carries a higher degree of risk given the extremely high levels of volatility in the market. This is a sharp reversal from March, when investors took out a record $326 billion in investments from long-term funds (mutual funds and exchange traded funds, or ETFs)—three times the dollar amount of $104 billion withdrawn in October 2008.

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