Why is the Market Going Up?

Conversations with clients since the start of the pandemic and recession have consistently ended up in the same place- “The stock market and the economy seem to be completely disconnected.” While we believe there are still observable connections between the market’s actions and the fundamentals of the economy, there is also an element of truth to this statement. There are several factors we think are worth discussing that explain the longer term and current relationship between the market and the economy.

1. The stock market is not the economy

The best explanation I’ve ever heard of the relationship between the stock market and the economy comes from fund manager and author Ralph Wagner: “There’s an excitable dog on a very long leash in New York City, darting randomly in every direction. The dog’s owner is walking from Columbus Circle, through Central Park, to the Metropolitan Museum. At any one moment, there is no predicting which way the pooch will lurch. But in the long run, you know he’s heading northeast at an average speed of three miles per hour.”

In this analogy, the dog is the stock market and the owner is the economy. In the short run, the results of the stock market have almost nothing to do with the performance of the economy as a whole. The chart below is a good depiction of this relationship. The blue line represents the US GDP (the owner) and the orange line shows the earnings of all the companies in the S&P 500 (the dog). These lines follow similar long-term trends, but the S&P earnings diverge wildly from the steady march of US GDP. Furthermore, this is just the earnings of the S&P and doesn’t take into account all the other factors that go into actually pricing stocks- interest rates, investor sentiment, inflation expectations- the list goes on. Those factors fuel even larger divergences from GDP.

2. Proximity Bias

Proximity bias is a cognitive bias that affects all investors.  Also known as familiarity bias, proximity bias occurs when we extrapolate our own experiences or familiarities to our thinking about investments. This cognitive bias manifests itself in many different ways. For example, most people know a lot about the industry in which they work. This could lead them to over-allocate their portfolio to their own industry. Others are deeply in tune with the news and trends in their own city or region. This may lead them to extrapolate their local experience and incorrectly assume the same trends were occurring all across the country.

The fact is, each of our experiences are different but no one’s individual experience is representative of our collective experience or even the average experience. This is perhaps the greatest argument for diversification in investing. Diversification forces you to invest in companies operating all across the United States and the world. A diverse portfolio contains companies whose operations you deeply understand and those you don’t. Diversification is an antidote to proximity bias.

How does this relate to the current pandemic? We are all seeing business closures and unemployment in our local communities and thinking the same thing- “If all these people and businesses are struggling, how can the stock market keep going up?” It’s a natural response, but it is flawed in its core assumption- “The businesses I see and interact with are experiencing difficulty, therefore all businesses are experiencing difficulty.”

There are many businesses that have been not only surviving, but thriving in the face of the pandemic. There are the obvious ones like Clorox and Zoom; and the not-so-obvious ones like realtors serving the suburbs. Any business that supports remote work has been crushing it. These are companies like Apple, Microsoft, Google, Salesforce.com, Cisco, RingCentral, and Slack. The pandemic has essentially forced more companies to start using their services.

3. Giant corporations play by different rules

It’s often said that time is our most precious resource because the time we have is strictly limited- bookended by birth at one end and death at the other. However, if you have enough money, you can in fact buy more time. Enough money can buy you a housekeeper, a landscaper, a concierge doctor, a personal chef, a private jet- you get the picture. The point is, with enough money, you can buy yourself time to do the things you want. Even when it comes to time, the uber-wealthy play by a different set of rules than the rest of us. The same is true for businesses.

As the Fed has lowered interest rates across the board through various means, the cost for large corporations to finance debt has plummeted. In our last newsletter, we noted that Amazon recently issued 3-year bonds for 0.4%. If you own a small business, good luck getting a rate below 1%. The ability to access funds at rates well below inflation has ensured many publicly traded companies (who otherwise would not) will be able to survive. Though the government has created several programs to help small businesses, their access to capital simply isn’t the same.

4. Market indexes are market-cap-weighted

While we have mentioned this in prior notes, it is worth repeating: the companies that were positioned to benefit the most from this unforeseen pandemic also happened to be the largest companies in the world before it happened. This enabled these mega-cap companies to get even larger. Furthermore, when we talk about the performance of the “market” what we’re really referring to is the performance of an index of individual stocks. Most indices are market-cap-weighted, meaning the larger the market value of the company, the larger the influence its shares have on the performance of the index.

The chart below compares the performance of the market-cap-weighted S&P 500 (the purple line) to the S&P 500 equal weight index. The equal-weight index treats all the S&P 500 companies equally- regardless of their size. As you can see, the market cap index has beaten the equal weight index by about 9% year-to-date. That’s a huge differential! This shows the incredible influence of the biggest companies on the performance of the “market” as a whole.

Apple, Microsoft, Amazon, Facebook, and Google have now become so large they represent roughly 19% of the value of all the publicly traded companies in the United States. Their year-to- date performance has been spectacular, notching gains of 50%, 35%, 73%, 21% and 10% respectively. This is, in large part, what’s powering the market.

In the end, it is probably impossible to ever really create a narrative to neatly summarize the thinking of millions of investors. However, we believe the four facts we described above are the most important in understanding the differences between what’s going on in our local economies and what’s going on with publicly traded companies.

There are also other factors in play beyond the ones described. Certainly, the actions of the Fed are responsible for some (or even a large part) of the market’s performance. On the negative side, we have also observed many instances of very speculative behavior from retail investors- for example, betting that companies that have declared bankruptcy aren’t actually going bankrupt (such as Hertz). It’s also entirely possible that investors have in fact paid too much for the companies that have seen their shares rise. In times like these, we remain vigilant and look for signs of bubbles. The trouble with bubbles is that you often don’t know you’re in one until it pops. While we feel very good about the way our portfolios are positioned right now, we have made some selective moves in recent days to add several stocks we feel are both cheaper and less tied to technology and healthcare. This should help balance out headwinds from the mega-cap tech stocks should those headwinds arise.


-Roy & Robert Sokolowski