The 'rising stocks are ignoring the terrible economy' crowd is missing the clear reasons for the market's surge
- Despite the pandemic-related struggles of the US economy, major US stock market indexes are hitting record highs.
- Pundits and financial media have pointed to this as evidence that the stock market is disconnected or ignoring the economy.
- But while the stock market isn't the economy, there are some clear economic reasons for the recent upswing.
- Neil Dutta is Head of Economics at Renaissance Macro Research.
- This is an opinion column. The thoughts expressed are those of the author.
- Visit Business Insider's homepage for more stories.
Mr. Market has turned into everyone's favorite punching bag, a heartless fellow utterly divorced from economic reality. This bashing of the stock market as divorced from reality has been par for the course over the past few weeks.
The Wall Street Journal recently noted, "Although the stock market has erased its losses suffered during the pandemic, the economy appears to be telling a different story."
Nobel Prize-winning economist Paul Krugman dedicated a whole column in the New York Times to the idea. And notable commentator Mohamed El-Erian recently proclaimed that "the economic/market disconnect grows ever more" on a day of better than expected US economic data no less!
The idea that stocks are divorced from the "reality" of the economy isn't exactly groundbreaking analysis. It has been a reliable trope for as long as I can remember. An article six years ago from CNNBusiness asked, "Why hasn't Main Street recovered like Wall Street?"
"The stock market is not the economy."
This platitude has long been used to say the market is either irrational, divorced from fundamentals or ignoring the economy altogether. It's a way for analysts to dismiss the market's ascent even if the level of economic activity is still depressed. There is only one problem: the stock market is not nearly this stupid.
It's about momentum, not level
Yes, it is fair to say that the stock market and economy are looking at different things.
This is because most of the firms traded in the equity market are in the business of selling goods to other businesses and households. By contrast, the US economy has a lot of service sector activity that is not captured in the equity market. A trip to the barber or dry cleaner is not something that registers in equities, but these people to people services make up a large chunk of US gross domestic product.
However, this is quite different than saying the market is ignoring the economy completely, which is what many are doing today.
For starters, stocks tend to care less about whether the economy is "good" or "bad" in level terms, but do tend to care about where conditions are "better" or "worse." This is one reason why stocks, a growth momentum variable, tend to slump in recessions and rise early on in recoveries even when unemployment is still elevated.
More recently, since the pandemic ended, economic data has largely been coming in ahead of consensus estimates, why wouldn't stocks rally in that case?
Importantly, it is pretty clear that the stock market is rewarding those firms doing well and punishing those firms doing poorly in today's economy. This undercuts the idea that there is a large disconnect. Our nearby figure tells this tale. The figure plots the percent change since February of S&P 1500 sub-sectors against the comparable retail sales category. The results send a clear message: the market is not, not the economy either.
As an example, non-store retail spending has surged since February and so have share prices for internet and catalog retailer firms like Amazon. Home improvement store spending has advanced and so have prices for home improvement retailers. Department stores and clothing retailers have seen sales crater and the stock market reflects that.
Worried about people not making their rent? Well, residential REITS have seen share prices sink since March. Travel and tourism? It's not as if airlines, hotels and cruise lines are leading this stock market recovery.
In short, the stock market may not be the US economy, but it is not ignoring the US economy either. Those analysts that continue to lament the market's rise would be better served trying to understand why they've been wrong instead of regurgitating mindless platitudes about the market's alleged irrationality.
Neil Dutta is Head of Economics at Renaissance Macro Research. In this role, he analyzes global economic and cross-asset market themes, providing leading-edge forecasts for institutional clients. Before his current role, Neil was a Senior Economist at Bank of America-Merrill Lynch covering both the US and Canada.
This is an opinion column. The thoughts expressed are those of the author(s).
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