The Stock Market’s Connection to the Real Economy, or, Is the Economy a Bubble?

Culture

Dec 10

Abstract

Driving Research Question:

Do current stock prices and 2021’s strong market fail to reflect the present state of the economy?

The United States stock market has experienced a period of incredible prosperity over the last couple of years. People marveled at the economy’s resilience as stocks shrugged off the effects of the Covid-19 recession to reach new all-time highs.

But has the economy really bounced back, and, if so, has it been as successful as so many people think? Though many believe that the stock market and the economy are the same thing, this isn’t true- That misconception emerges from the fact that the stock market tends to be so closely tied to the economy that its trends reflect it. However, the market can become disconnected from the economy, as has happened in many previous instances such as the tech bubble. Though some aspects of the situation point to the market still being related to the economy, there are also factors that indicate that the market is becoming disconnected.

The objective of the research conducted in this paper is to analyze the stock market and the economy and discern whether the two remain tied together, and therefore, whether the market’s current state can be considered a bubble.

Introduction- The Situation and the Problem

Before the Covid-19 recession, stock prices were steadily increasing, and, according to the Center on Budget and Policy Priorities, the economy had experienced its longest recorded period of economic expansion. As Covid-19 approached, the consensus was that the ensuing recession would plunge the economy into its darkest period since the 2008 housing crisis. This prediction came true as stocks plummeted and a brief period of widespread bear market prosperity emerged. Short positions flourished, especially those taken against companies that would be rendered incapable to operate by the lockdown and the social distancing mandate, for example, cruise lines. However, though the recession had been the worst one since 2008, its impact on stocks still wasn’t as major as people had expected. Though the Dow Jones Industrial Average, the Nasdaq, and the S&P 500 dipped, the decrease didn’t last long, and the indexes rebounded within 4 months. Statistically, the Covid-19 recession was “the deepest but shortest of all recessions in the post-World War II years.” (Center on Budget and Policy Priorities, 2021). Some stocks even profited from the pandemic, for example, Amazon, which traded bullishly during the pandemic amid the widespread shutdown of brick-and-mortar stores. Soon, the market rallied, putting an end to a seemingly short recession. In fact, the market climbed, and climbed, and kept climbing, pushing far past the pre-recession peak to never-before-seen heights. According to Google Finance, the S&P 500 climbed to a height of 39% above its pre-covid peak. A new heyday of stock trading took place as the market boomed: Young and inexperienced traders flocked to the market by way of easily accessible apps, and seasoned brokers doubled down on investments as the market became unbeatable. Retail traders (Individuals who buy stocks on platforms such as Robinhood) have become an important part of the market: “Weekly single-stock call-option buying activity from relatively small orders—usually from retail traders—surged to more than $8 billion as of Monday [November 11]” (Sonenshine, 2021).

However, notwithstanding the stock market’s current utopian state, the pandemic has left the economy with some lasting issues. To begin with, lockdowns and restrictions have decimated the supply chain, leaving companies such as semiconductor giant Nvidia lacking in inventory. The supply chain has shown signs of recovery, but there’s still a long way to go before companies like Nvidia can replenish their inventories to pre-pandemic levels. The supply chain issue coupled with higher wages has taken its toll on profit margins, which in turn have caused earnings estimates to stagnate. Barron’s stated that “the aggregate S&P 500 2022 analyst earnings-per-share estimate has risen 0.7% in the past month” (2021). This and rising stock prices have led to growing Price/Earnings ratios that have surprisingly not yet been offset despite rising Bond yields, which historically have caused a decline in stock valuation. The decline in stock valuations could still be realized, but if it is not, it is an indicator of an abnormality: A diversion from normal stock trends and a disconnect between the current stock market and the actual economy. Finally, a major problem is interest rates. Until recently, the Federal reserve maintained the line that the current level of inflation is transitory. However, as inflation continues to rise, the Fed has ended up in a precarious situation, and the prospect of higher interest rates has become increasingly more likely, with the alternative of allowing inflation to go even more out of control than it already is. Despite this, the market has continued to thrive. According to MarketWatch, “equity investors might have to soon stop pricing in their own thoughts on the markets and surrender to economic reality.” (McEnery, 2021). These problems, when juxtaposed with the current state of the market, could indicate that the market is currently failing to represent the actual economy.

Evidence and Analysis of Aspect 1

If there is in fact a disconnect between the market and the economy, then much of it is due to euphoria. Euphoria (which many of today’s young investors would call “hype” or “overhype”) is a process during which stocks become disconnected from the market. In this phenomenon, people buy a stock due to assumptions and expectations, and the valuation of a stock fails to mirror the actual earnings and value of the company it represents. Euphoria has been a major element of past asset bubbles such as the tech bubble. Stocks become overvalued due to this phenomenon and, in the worst-case scenario, the market itself becomes overvalued.

There has been euphoria surrounding the market in the past two years. “Story” stocks, valued based on press coverage and high expectations rather than fundamentals and realized earnings, have become hugely popular as a boom in IPOs has taken place. Penny stocks became hugely popular toward the middle of 2021, and cryptocurrencies, a bubble in and of themselves, rose to vast popularity. As the introduction mentioned, retail traders have become a large element of the market, but their involvement has been primarily euphoric: “Meme stocks” rose to popularity among Robinhood traders, who brought previously unknown stocks like CLOV to incredible heights before a widespread meme stock crash near the middle of the year. Meme stocks showcased the most concerning tool of retail traders: Controlled euphoria. In this strategy, retail traders plan online to buy low stocks en masse, causing the price to skyrocket. At this point, most of the traders would sell, completing a maneuver referred to as the “pump and dump”. Besides its crushing effect on short sellers, this strategy was also a case study of the detachment that euphoria can create between the market and the real economy: After a “pump and dump”, a stock would usually drop 50% or more due to its lack of fundamentals, showing that the influx of excited traders fully fueled its peak prices.

Evidence and Analysis of Aspect 2

Analysis of the people involved in today’s stock market is telling. However, looking at human behavior only goes so far in terms of analysis. Some assumptions can be made about investors and how they might react when interest rates go up, or how the market is trending toward euphoric. However, it is impossible to truly state that the market has become euphoric, and therefore that it is disconnected from the economy, without looking at the numbers. In this case, the numbers to look at are Price/Earnings ratios, one of the fundamental elements of basic investing. Basically, P/E ratios divide the price of a company’s stock share in US dollars by the company’s earnings per share. While they become less applicable in more advanced investing strategies, P/E ratios still are vital when testing whether stocks are overvalued in a widespread manner.

P/E ratios actually do not show a disconnect. On the contrary, though they are growing, they still show a fairly close relation between the market and the economy. According to Fisher Investments, “P/Es don’t fit the narrative of a wildly overpriced stock market… Yes, P/Es exceed pre-pandemic levels, but they are down by over 10 percentage points since peaking on May 7—even though the S&P 500 is up 12.0% since then through yesterday’s (record-high) close.” (2021). This line of reasoning states that since P/E ratios have decreased since their peak, they are following a logical trend and there’s no cause for alarm. A decent average market relation between price and earnings does indicate a close relation between the market and the economy. This information is vital to the counterargument, as if it is accurate, it means the market is still connected to the economy, and the thesis receives a major blow.

The chart from the Fisher Investments article, originally from FactSet, is attached below:

(FactSet, 2021)

The chart confirms the evidence provided by Fisher Investments. P/E ratios indicate a return to normalcy from sky-high P/E ratios that could have meant a disconnect. According to P/E ratios, the market has nothing to worry about.

However, there is another metric which is more finely tuned to detecting euphoria: The CAPE ratio. CAPE stands for Cyclically Adjusted Price to Earnings: Instead of using current earnings, the CAPE uses a 10-year inflation-adjusted average of earnings. This is because, according to Fortune, “Using the current P/E to gauge if stocks are rich or cheap can be misleading. That's because when profits hit a trough so low they're destined to rebound, multiples look artificially high, and when earnings reach unsustainable, bubble territory, P/Es appear deceivingly modest.” (Tully, 2021). The CAPE ratio has hit high levels during such crises as the Tech Bubble and the Great Depression. Now, the CAPE is high again. Over the last couple of years, it has steadily climbed to alarming levels. The metric reached 40 recently, leading to some alarm among market analysts. The finance sector, on the other hand, challenged the CAPE’s relevance, questioning the long amount of time it has spent in the red and stating that low interest rates justify higher multiples.

However, there are two issues with that argument. The first issue is that lower interest rates may not be around for long. As was mentioned earlier, inflation rates that were dismissed as transitory appear permanent, and it’s looking ever more likely that the Federal reserve will have to raise rates. If rates go up, the multiples are no longer justified, and the red flag that the CAPE raises is unquestionable. Independent of the interest rate scenario and of the finance sector’s justification of the situation, there is another alarming factor: Though many say the fact that CAPE ratio has been in the red for a long time shows that there is little cause for alarm, there was one notable instance where the CAPE remained in the red for a while before a market collapse: The Tech Bubble. During the 21 months before the dotcom bubble burst, the CAPE remained high, leading many to say that it was irrelevant. However, these critics were silenced as stocks plummeted due to widespread overvaluation: “When the Shiller PE reached the big Four-O for the first time ever in January 1999, the S&P registered 1247. Four years later, in January 2022 [sic] it had dropped to 896, shedding over 22%.” (Tully, 2021)

When these factors are evaluated, they indicate that the CAPE is most likely still accurate.

Conclusion

After considering the concerning state of the CAPE ratio and the habits of today’s investors, it appears increasingly likely that the market is experiencing euphoria. This factor, when assessed alongside the Federal Reserve’s jeopardy and Bond yields’ lack of effect on the market, indicates that the stock market has in fact become disconnected from the economy. In the worst-case scenario, the market’s current state could even be a bubble. With that information in mind, it would be most prudent to avoid new long-term investments and wait for either a decrease in the CAPE as the supply chain recovers and business returns to normal, or for a market devaluation and potential follow-up recession to the seemingly finished Covid-19 crisis.