After the recent downturn in the stock market, we have seen markets make a somewhat significant recovery. But we are still going through a pandemic, right? Does this make sense? How can the stock market have seemingly recovered when, companies are still operating at limited capacity, and the ability for us to consume goods and services is still restricted?
As investors, it’s understandable to feel confused about why the stock market has seemingly recovered while the current economy is still in a state of slow down.
In this article, we give some insight into why stock market performance isn’t necessarily reflective of the current economic situation.
What types of companies trade on the stock market?
For a company to list on the stock market it needs to have met specific requirements around market value and financial resources.
Some large public companies have already seen significant challenges from the pandemic, such as the large airline companies, however, the likelihood is that smaller, local and family businesses are the ones that are going to be hit the hardest.
The largest companies on the stock market have substantial financial resources behind them thus are more likely to have enough to ride out the current challenges of the pandemic. In contrast, many smaller companies may go out of business. While this brings about real hardship for the local economy, as they are not traded publicly, this is not fully reflected in the stock market.
Markets are looking forward
When observing current economic indicators, such as unemployment, the data is mostly a result of what has already passed.
Stock market prices reflect the aggregate of how all participants believe companies will perform in the future. The markets have already priced in what has already happened and what is happening today.
When the extent of any economic damage has been realised, the stock market has priced this in and is already looking forward and hence there is a disconnect between stock market prices and current macroeconomic data.
Of course, the stock market is not 100% efficient, but it processes information in a fraction of the time that any individual could. The millions of trades that take place each day reflect all publicly available data and factor in the current level of uncertainty in the economy.
Bad news beats uncertainty
The outbreak of the virus was an unprecedented situation and the steep drop in markets associated with the outbreak was primarily due to uncertainty over what was going to happen next. After countries and governments have had time to react and make a strategy for recovery, markets have adjusted. While the near future is still not clear, less uncertainty means markets can make more realistic expectations.
For example, even it takes between 12-18 months for a vaccine to be developed, 18 months of a company’s revenue only represents a small portion of its overall value. So the outlook for the company’s future may be more favourable than today.
Many governments have announced various stimulus packages to help their economies get started again.
While the long-term impact of such significant stimulus is unclear at this stage, in the medium term, this has given the stock market confidence that there will not be issues around liquidity or access to credit for example and that business will resume to some level of normality.
It takes time for stimulus packages to roll out so the current economic situation and lockdown status of countries may not be aligned with medium-term market expectations.
Is this all over?
Should we believe that since the markets have made a significant recovery that we are out of the woods yet? The answer to that is that still, nobody knows what the future holds even as things get less uncertain.
There are different forces at play that determine stock market outlook compared to the current economic situation. The lesson to be learned is that the stock market is no place for short term investing based on short term market events.
Instead, focus on an investment strategy that is in your control, such as having your investments set up as to weather market downturns, remaining disciplined and focused on longer-term outcomes.
If you feel you need help with making a plan that is robust for the future, get in touch today