While most people generally understand that the stock market and the economy do not move in lock step, there is still an underlying belief that a strong market reflects a strong economy. But according to that logic, our current economy must be historically strong. If this strikes you as strange, given that we are in the midst of a destabilizing and polarizing pandemic, and a period of political risk that threatens the foundations of the Republic, that’s just because you don’t understand how the fundamental relationship between the stock market and the economy has changed. Believe it or not, strength on Wall Street is now driven by weakness in the broader economy.
Perhaps the most reliable metric for stock valuations is the Cyclically Adjusted Price to Earnings (CAPE) Ratio, which compares share prices to average earnings over a 10-year period, thereby smoothing out short term conditions. An August 6th Fortune article pointed out that CAPE ratios (which were 31.1 then, and have since moved up to 32.65) have only been as high or higher on three occasions over the past 132 years of available data: in 1929 right before the Great Depression, in 1999 right before the dotcom crash, and then briefly in September of 2018. And while we now know that the optimisms that fueled those prior spikes were largely, if not totally, illusory, at least it made some sense that stocks were rallying. (It’s also worth noting that stocks crashed in the immediate aftermath of those spikes). But where’s the optimism that’s fueling the markets now? Sure, Donald Trump may be wildly waving the pom poms, but no serious economist or investor thinks the economy is poised for greatness. Instead, this rally is all about the printing press.
With the Fed now delivering more stimulus than ever, and promising to keep interest rates at zero for as far as the eye can see, many attribute the surprising rally to a “never fight the Fed” bias, which has banished investor fears through the assumption that the Fed will vanquish every dip with even more stimulus. The low rates also “push” investors into stocks because they nearly eliminate the returns available through fixed income. But these forces, which have been with us, off and on, for the past 20 years, don’t fully explain why the current market is so strong. The Covid pandemic has actually created conditions whereby what hurts the economy and Main Street businesses actually helps the S&P 500.