The fruits of the market’s boom have not been felt everywhere.
The economic impact of the COVID pandemic has been measured in many ways, as will the extent of recovery as the pandemic wanes. Political figures, TV talking heads and other opiners often cite the stock market, in particular the widely reported Dow Jones Industrial Average, as a gauge of overall economic strength. It’s a convenient measure to use, but it’s not a very good one.
For all the claims of officials, candidates and commentators, the stock market is not the economy. It’s a poor way to try to measure the economy, as the pandemic and its aftermath make clear once one understands what the stock market is and isn’t. This helps explain a robust stock market in an economy with high unemployment, reduced GDP and other indicators of significant weakness.
That may seem counter-intuitive, but it’s not, according to Harbert Eminent Scholar Jimmy Hilliard. “The health of the real economy is measured contemporaneously by GDP, GDP growth, unemployment, consumer sentiment and similar measures. By contrast, stock market prices are forward-looking,” he said. “They depend on forecasted cash flows that extend far into the future. Today’s booming stock market reflects the prediction of a robust future economy.”
That future economy may seem pretty far off, especially in a world of instantaneous communication and implementation of decisions. “Using reasonable estimates of earnings growth and discount factors, we can develop examples where 80% of stock price is determined by earnings that occur after five years,” Hilliard said. “This also means that an isolated event that happens this year does not have a large effect on stock prices. Using the same logic, we note that some of today’s high-performing stocks have negative earnings. But their prices are based on forecasts that earnings will grow rapidly after some point in the future.”
Yet to hear most of the public discussion about it, one would think the stock market is a snapshot of what’s happening now. Technology columnist Farhad Manjoo, writing in the New York Times, noted that the stock market’s “gyrations during the last few decades have made it less and less of a reliable proxy for understanding the health of the economy at large—even if presidents and pundits still point to it as a benchmark that makes a difference in people’s lives.”
Not entirely in jest, Manjoo suggested that perhaps stock market reports should carry the same “For entertainment purposes only” warning used by palm readers and fortune tellers. “Treating stock prices as an economic indicator distorts Americans’ views about what’s actually happening, who exactly is winning and losing, and what sort of growth really benefits people in the economy at large,” he wrote. “The more we focus on the market, the less of the economy we see.”
Hilliard described the stock market as a “useful but incomplete indicator of long-term economic health,” noting that forecasting is complex and always hazardous due to unexpected events. Major forecasting entities such as the Congressional Budget Office, the Federal Reserve Board of Governors, the St. Louis Federal Reserve Bank and various money center banks weigh many economic factors in making these forecasts.
Still, the popular perception persists of the stock market, in particular the Dow, as a sound measure of the economy. In the political realm, the Dow is often cited as proof that the economic policies of a party or a candidate are working, or that the policies of the other side are failing. This political shorthand may be convenient, but the reality is not that simple.
“It is true that the market ‘votes’ on economic policies,” Hilliard said. “However, some caveats are in order. Economic effects may lag policy changes. And there are many other factors that affect markets. Think COVID-19. Or one might hesitate to attribute the ’90s boom to economic policy when the primary driver was likely the emergence of the Internet.”
With talk of recovery comes the question of who’s doing the recovering. The stock market offers a skewed picture of the extent of recovery and the possible beneficiaries. That’s not everybody, not by a long shot. A rising stock market is not that rising tide that lifts all economic boats.
About half of Americans own stock, but for most it’s a relative handful of shares in a 401(k) or other pension account or maybe a few shares in a personal investment account. Although important to the individuals, in terms of value in the overall market, these holdings are small. As Manjoo noted, the wealthiest 1% of Americans hold almost 40% of the value in stock accounts and the wealthiest 10% hold a whopping 84%.
High degrees of concentration persist among companies as well as stockholders. In the S&P 500, a more broad-based market measurement that Hilliard called a “much better” indicator of market performance than the Dow, more than half the growth in 2020 came from just three stocks—Apple, Microsoft and Amazon.
That might look like an unhealthy factor for economic recovery, but it’s really not an issue for investors. “Savvy investors do not worry very much about the concentration in these three stocks,” Hilliard said. “Our research shows that the market is largely efficient. This means that ‘prices are right’ and in such a market you hold each stock in proportion to its market capitalization.”
Market capitalization is the total dollar value of all outstanding shares of a company at the current market price. Suppose, for example, that Apple’s market capitalization is 10% of the total market. Apple should then make up 10% of your portfolio. More than that and you’re essentially betting on Apple. Less than that and you’re betting against Apple.
Whether they see it as a measure of the economy or not, and even if their holdings represent but a sliver of total stock value, more individuals are investing in the stock market through retail trading apps, no-cost brokerage services and other easy-to-use mechanisms. There’s obvious appeal in a surging stock market and the prospect of high returns. With interest rates low and other investments offering minimal returns, this might look like a path to recovery for some.
“Historically, research has shown that experiencing a significant economy-wide event affects stock market participation,” said Danny Qin, finance professor at Harbert. “So, the high market returns after the short March 2020 bear market may have increased participation.”
For some, investment became something of a sport during a time of empty arenas and dark stadiums. “Many individual investors may have used the stock market as a substitute for traditional gambling venues, such as sports betting, when sports were on hold,” Qin said.
Qin also noted that the emergence of easy no-cost brokerage services, especially mobile interfaces, and fractional buying of stocks “lowered the barriers to entry for individual households and enabled a democratization of stock markets.”
Ease of entry, however, does not equate to exiting with profit. Retail trading abounds with pitfalls.
“The conventional wisdom of trading stocks is that the market is efficient, a word that loosely means actively picking stocks to trade will lose out in the long run to a passive investment in a market index fund,” Qin said. Retail traders may trade too frequently, focus on recent prices or 52-week highs, or fail to diversify their portfolios. They may also look past the crucial risk-return tradeoff, a perilous decision if potentially high returns carry unacceptably high risk, he said.
That could really hinder recovery, in a most personal way.
Should we protect investors from themselves?
Anyone investing in the stock market knows—or certainly should know—that there is potential for the loss of some or all of the amount invested. But is that truly a universally understood reality, especially for less experienced investors eyeing riskier strategies such as short selling or considering unconventional investment maneuvers such as the Reddit/GameStop effort earlier this year?
It’s a question that interests Harbert alumnus John Roth, vice president and chief compliance officer at Nassau Financial Group. “Technology and broker-dealer competition have resulted in more access to the equity markets than ever before, and low interest rates have caused many to flock there in search of profit,” said Roth, a 1998 Finance graduate, in a recent interview with HarbertPodcast. “Efficient access to financial markets certainly provides positive avenues to wealth generation, but I struggle with the question of whether some investors should be protected from getting in over their heads.”
The GameStop scenario, in which a surge of coordinated retail trading temporarily sent the stock price soaring even though the company is struggling, was “merely a technical event that has nothing to do with the fundamentals of the company,” Roth noted. “In fact, the soaring stock price defied the company’s fundamentals and, predictably, began to fall back to reality.”
For securities regulators, such market maneuvering requires weighing the potential harm to investors against the freedom of the marketplace. “Regulators are in a tough position because when they establish a rule, they have to be sure to avoid casting too wide a net that discourages or outright prevents healthy market activity,” Roth said.
Analysts saw the GameStop retail trading surge as the small investors’ slap at the big players in finance, such as hedge funds and other large institutional investors. For many retail traders, however, the extreme volatility in the stock price quickly became a substantial loss for those who either got in late or held on too long. “It is one thing for someone to throw in a few dollars just because they want to stick it to the so-called ‘bad guys’ on Wall Street,” Roth said. “But real harm is being felt by those who, for example, threw all their savings into it, and that’s the type of person who may need to be protected.”
