Why is the stock market doing so well when the economy is doing so poorly
In Coronavirus and the stock market: 6 months later, we observed that the stock market has already rebounded from the shock that happened in March. That's when the Coronavirus started hitting countries all over the world. I ended the article with a small note:
It's important to note that the stock market going well does not mean the economy is doing well.
I wanted to dig a bit deeper into that topic, as it's a common misconception. Before going further, I want to point out that I'll not be discussing why the stock market is doing well. There are many factors at play, and in the end, all we have access to is incomplete information. Stock markets is driven by the emotion of investors, which is why it's hard to predict it. What I'll be explaining is why we shouldn't be surprised that it's doing well. Let's start with a few definitions we'll use to explain the relationship between the economy and the stock market.
First, the economy. While it's a big topic in itself, in this article I'm using the term to encompasses the overall health of the production, use, and management of a country's resources. On a smaller scale, this includes how well your neighbourhood restaurant is doing, just as much as the chain grocery store, the hairdresser salon you go to, etc. For the economy to go well, a majority of its pieces, the companies and individuals part of it, must also be doing well.
Second, the stock market. Whenever I refer to "the stock market", I'm referring to the aggregate stock market, which means the grouping of all stocks that comprises a stock market like the Canadian TSX 🇨🇦 and the American NYSE 🇺🇸. This is a lot easier to define because there are a bunch of indexes that exists solely to track it, and ETFs that track those indexes. In the previously linked article, we've looked at VCN and VTI as indicators of the whole Canadian and American markets. So we have an objective number on which to base ourselves.
Based on these definitions, what has been shown historically is that when the economy goes well, then the stock market does well. This makes sense when you think about it: the stock market goes up and have money on hand to pay out dividends when companies make a profit, and companies make more profit when the economy is doing good. Remember the previous definition of the economy? Yes, the economy is doing good when companies and particulars within it are doing well. So up it goes. In logical terms, this is called an indicative conditional: if A is true, then B must be true. If the economy is good, then the stock market goes up. What's important to note is that this is the only possible information we can get out of this conditional. If A is false, we cannot know what B will be. And it's impossible to know what A is even if we know whether B is true or false. This can be summarized as such:
A is true, B is true => this is possible
A is true, B is false => this is impossible
A is false, B is true => this is possible
A is false, B is false => this is possible
PS: You may have learned this at school in either math (as logical language study) or philosophy (as natural language study) classes. It's an important building block in the definition of proofs, and without it, there would be no computers today.
That's all good until we add the human mind to the equation. While we can reason about logic when we focus, our brains often confuse situations and see relationships where none exist. In this case, it comes from a common logical fallacy called affirming the consequent. Without going into too many details, the fallacy is about inversing the indicative conditional flow. So we hear "if A is true, then B must be true", and we intuitively believe that "if B is true, then A must be true".
Back to the case at hand, what does that mean? It means that while we can say that "when the economy is good, the stock market does well", this doesn't imply that the economy must do well for the stock market to do well. That's all there is to it.
So it's fair to say that right now for 2020, the economy of most countries is not doing well. There are some exceptions, and every situation has winners and losers., but currently, a majority of companies are still struggling so we can say the economy is not doing well. In light of what we've learned today, what does that mean the stock market should be doing? Exactly, we have no idea. It could do better, it could do worse, but nothing can be inferred just by looking at the current state of the economy. Why? Stock markets are forward-facing, meaning the price of a stock today represents the value investors as a whole believe the company will be worth in the future. Even if profits are down today, there can still be confidence that they will be up tomorrow.
This is the exact reason why looking at the stock market as a proxy for the economy is a flawed idea. Our mind likes to take these shortcuts, but it doesn't make them true. We've seen that the economy doing bad and the stock market doing well is possible. It's the case today, and it has been the case at many other times in history.
Will the economy improve shortly, as the stock market believes it will? Maybe, beats me. Anyone telling you they know is full of it. Knowing our limited knowledge, the best we can do is invest in a balanced and diversified portfolio. In 30 years, there will be living adults that haven't experienced this pandemic, just like there are adults today that never lived the world wars or the dot-com bubble. Your portfolio will not remember either.