After a massive selloff following the Covid-19 lockdown, stock markets – and the US equity market in particular – have embarked on a spectacular rally, which Bloomberg columnist John Authers has rather wonderfully described as “The Most Hated Rally in History”. This nicely sums up the bemused thoughts of many investors, who simply can’t understand why markets have turned aggressively bullish despite the state of the “real” economy – i.e. galloping unemployment, collapsing consumer confidence, crashing manufacturing sector output and growing concerns that massive central bank intervention might prompt future inflation. Why on earth would investors be bullish about this sorry state of affairs?
This debate between the bears and the bulls highlights a little understood point. The stock market is not the “real” economy. Of course, there is a connection between the two. If high streets, factories and global trade are booming, then that should boost corporate sales. This, in turn, will lift profits, some of which will find their way back to investors as increased dividend payouts and share buybacks. But there is no simple equation which says that “better macro-economic news = higher share prices” (or vice versa). Indeed, over the last few decades, research by many academic economists has suggested that the correlation between long-term GDP growth and long-term stock market returns can be negative, a finding backed up by a 2010 paper from analysts at index provider MSCI. In other words, there’s little clear link between economic growth and rising markets, to the extent that in some cases long-term growth can go hand in hand with weak returns. The brutal reality of modern financial markets is that they are not an awards system for ranking economic growth. They are an unruly collection of investors with many different imperatives, outlooks, behavioural biases and requirements. They are also not purely rational. Investors get carried away. They sometimes become overly optimistic (greedy) and boost share prices to very high valuations, based merely on hope; or they become too pessimistic (fearful) and punish share prices disproportionately by over-weighting worst-case scenarios.
If we can say anything about stock markets, it’s that they are a weighing machine powered by a guessing game. What do we mean by this? Investors are forward-looking – they obsess about expectations for profits and dividends. So a rough and ready rule is that markets tend to be priced at something equivalent to expectations for profits, sales and cashflows six months in the future. In other words, the current share price is a stab at guessing what the near-term future holds. Those expectations are themselves a moving feast. Every quarter in the US, analysts carry a book full of estimates for likely earnings into their meetings with company bosses. Those bosses love to hit those expectations and even better beat them. This results in what’s called earnings surprises, which tend to drive share prices up. But in between these quarterly earnings meetings, analysts also quietly downgrade their earnings expectations, based on what they think is happening to the economy or the business. So we have a constant to-and-fro of expectations rising and falling.
We then need to add the other element mentioned earlier – investor sentiment, which has a huge impact on valuations. In bullish markets, investors will pay high multiples of corporate earnings (in other words, they’ll pay a higher share price for a given £1 of earnings). In more fearful markets, those valuations crash down. While the state of the “real” economy does have some impact on sentiment, other factors are at least as important, notably in recent decades, the actions of central banks. If investors feel that the Federal Reserve in the US is willing to pump more money into an economy, they’ll more often than not push valuations higher, even in the absence of increased earnings. There are other technical factors at work in the relationship between the “real” economy and financial markets. For example, many economists suggest that a significant part of economic growth comes from new (unlisted) enterprises and not the high growth of existing ones – this leads to a dilution of GDP growth before it reaches shareholders. All in all, the relationship between financial markets and the economy is complicated, fuzzy and nonlinear. And for investors in stocks and shares, there’s a more basic truth. The majority of returns from shares come from dividends paid, the growth in those dividends over inflation, and the subsequent reinvestment of said dividends back into the shares. So in reality, for long-term investors, it’s better to ignore the ups and downs of the wider economy and just focus on investing in good companies at good prices.