Is the Stock Market Divorced from the Real Economy?

- Sudarshan Kadariya

If you are a student of Economics, you would have written multiple times that “the stock market is the mirror of the economy” or “the stock market is the barometer of the economy”. With the experience of the stock market behavior in the time of Covid-19, do you still believe what you have written in those days is still the same and true?

Many people have now launched the debate on “The stock market is not the economy” and why you should for what exactly the cause? You just mind your business and make money from the market! The market as a rational yardstick of the economy is mostly a myth.

We have studied the efficient market hypothesis (EMH) which was a very good concept and a beginning of modern finance. It has been challenged by behavioral finance later on. The intention is that asset prices or the stock market are not the perfect reflections of their intrinsic values. Rather, the prices in practices are always more or less driven by behavioral factors among numerous other constraints. The market is inherently irrational so we cannot predict the upcoming market behavior or market crashes.

In the global context, economic activities have been severely contracted since the start of the pandemic in March 2020, and situations followed suit back home in our country. Unemployment numbers have surged to record levels which are yet to get down to their pre-Covid-19 period. The divorce of living in the city and not living in the crowded (even though) popular places has become the new normal social phenomena. The rentals in the mega-cities and cities are now decreasing and the prices of urban and rural properties are attracting new buyers due to the work-from-home culture which will not be going to get over soon!

In general, many small businesses are the sources of employment or self-employment in every economy. These small businesses have no access to the stock market. In the pandemic, those are primarily closing down. They are firing their employees or downsizing their investment, manpower, or they have seen lesser prosperity in the economic activities in the immediate future. It is equally applicable in any part of the global economy. But, these small business implications have not been reflected in the stock market, neither there would be any mechanism to incorporate small economic activities in the broader stock market.

Why US Stock Market at is all-time high despite pandemic?

Stock buybacks: President Trump had enacted the 2018 tax cuts which led to an inflow of cash for companies and companies used those cash to buy back shares from the open market led to stock prices soar.

Stimulus Package: Federal Reserve, the US central bank has injected massive amounts of money as stimulus into the banking system to support the families, small businesses, and big businesses to work on their financial hardships.

Low-interest rates: Persistent low-interest rates will likely last for a while is the positive stimuli for investors to invest in the stock market. When interest rates are low, stock prices often tend to go higher because stock prices are discounted by the time value of money (inverse relationship) and low fixed assets rate of returns encourage people to invest in the stock market.

Forward-looking: The stock market is the forward-looking mechanism that tends to incorporate the future valuation of the businesses. Investors may have seen the immediate prosperity of the business once the pandemic situation is over.

Why the stock market is termed the barometer of the economy?

We have studied the great depression of 1929-1932. We may not have sufficient information of that time but still, it has a greater impact on our wisdom! Similarly, many people around the world, specifically, Americans experienced the collapse or they may have listened to the story of their grandparents about the hardship during those periods. So, the people have an impact in their minds that the stock market crashes cause the severe economic downturn or vice-versa. In the period of the great depression, the benchmark index fell 86 percent from its peak and the economic reality was measurable.

This has brought the phenomenon that the stock market is considered as the mirror or the barometer of the economy. This may not be true if we get sufficient information of that time. But, people around the world have accepted that the stock market replicates the economy. An example would help us to understand better if it’s true, the top five US technology companies – Apple, Google, Microsoft, Facebook, and Netflix, doing a great business despite the Covid-19 pandemic situations and global financial contractions whereas many other businesses have severely affected by the situations. The employment situations have not been recovered and many families and small businesses are struggling to survive but the stock market is rising in the rocky mountain!

Article by Sudarshan Kadariya