This is a re-post of our 8th issue of our “WTF is going on with the Economy?” newsletter which talks about stock markets. You can read the original here. Get future issues delivered directly to your inbox. Sign up here.
lIt all started in late February.
The Coronavirus began spreading across Europe and the United States. Looking back on it, we could see it coming.
Yet at the time, governments in the west seemed to have their heads in the sand.
But just because officials weren’t looking didn’t mean that the stock markets didn’t take notice. Stock traders, along with prophetic epidemiologists, we’re the first to sound the alarm.
Starting on February 18th — two weeks before Italy locked down — traders began a historic sell-off.
The resulting panic created the fastest stock market decline ever.
In the following weeks, the rest of the world followed suit, resulting in the unprecedented economic coma we’re only now emerging from.
However, in the daily onslaught of news, you probably heard that stock markets are rebounding despite all of us still stuck indoors.
At first glance, this recovery makes little sense. We haven’t even begun to reopen the economy, but stock markets are showing strong signs of life.
If we look a little deeper, though, the story isn’t so rosy.
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Before we can get to that, let me quickly explain how the news reports the stock markets.
When you hear about stock markets in the news, you’ve probably heard these names tossed around:
- The S&P 500 (US)
- The Dow Jones Industrial Average (US)
- FTSE 100 (UK)
- The DAX 30 (Germany)
- The Nikkei 225
All of these are what we call indexes. An index is a collection of stocks in a market that (among other things) provides a snapshot of its performance.
Stock exchanges list hundreds if not thousands of stocks for trading. The stocks range from small(ish) companies to giant multinationals. An index helps separate stocks by company size, price, and value.
While indexes are tracking practically every aspect of each stock market, the news will focus on the most popular index.
Why? The main index for each market acts as a proxy for the overall performance. It’s not 100% accurate, but it is an effective way to report on the stock markets quickly.
How indexes are built is really cool. Well, “cool” for finance, not “cool” like that beach club that won’t let me in (bunch of jerks).
Index builders are free to set the membership criteria. These rules range from business type (like tech firms or consumer goods), financial performance, to overall company size. Firms can enter and leave indexes at any moment.
Each company in the index makes up a percentage of the total, known as a weight. The most popular methods are:
- Cap: short for market capitalization or the share price multiplied by the number of shares on the market. A company’s weight comes from dividing their cap over the total cap of the index;
- Price: where the value of a company’s share price determines its weight in the index and;
- Equal: with all companies having the same weight.
There’s much more to indexes, but for now, this will let us put the news in context.
Why are the markets recovering?
In short, they’re not, at least not in a broad sense.
The American S&P 500 index is a cap-weighted index tracking the 500 largest companies in the US.
If we break down the S&P 500 by sector (here’s the official website, if you’re interested), tech and healthcare make up 41% of the index.
As it would happen, tech giants like Facebook, Apple, Amazon, Netflix, Google, and Microsoft are in this sector. We’re all stuck at home right now and have never been so dependent on these companies. These firms are massive. Since the S&P 500 is cap-weighted, these tech giants have an outsized influence on the index.
If you throw in healthcare — an industry that thrives during a pandemic — it’s clear why some people will say the stock market is recovering. But if we scratch beneath the surface, things are bleaker.
Entertainment, physical retailers, restaurants, tourism, hotels, airlines, automotive, logistics, real estate, and manufacturing are all in freefall.
The lockdowns froze nearly all of these sectors. The economy isn’t going to reopen all at once. Travel and entertainment (like concerts and sporting events) won’t be back at full capacity until we have the Coronavirus entirely under control.
It could be that people bought into tech and healthcare, expecting the economy to be in the doldrums for the long-run.
Right now, like everything else, it’s too soon to say what will happen.
We’re only now unfreezing the economy. It won’t be until July that things will look normal-ish again (at least here in Europe, and if the deconfinement goes to plan).
It’s also worth noting that the S&P 500 isn’t the only index watched by journalists. Others around the world tell a different story. Indexes, where tech and healthcare stocks aren’t as prevalent, are still much lower than they were just four months ago.
Additionally, central banks around the world are playing a role. Back when the crisis first started in late February and early March, central banks began massive spending programs, buying bonds, and putting money into companies’ pockets. A lot of this cash wound up in the stock market, helping fuel a bubble.
Keep in mind that stock markets are “highly liquid.” This term means that investors can buy and sell stocks almost instantaneously. As a result, stocks react faster than virtually any other financial asset to the economy. Slower moving assets like bonds and real estate only reveal market trends in days, weeks, or even months.
Since stocks move so quickly, there are a lot of false-positives. Market gains from good news today quickly disappear on rumors of bad news tomorrow. Other indicators like bonds, deflation, and real estate tell a much longer-term picture. That said, it doesn’t mean we should turn a blind eye to the stock markets.
Keep your eye on how the sectors most hurt by the lockdowns perform in the next few months. If these firms begin to trend upwards, then perhaps the economy will recover faster. Otherwise, we’ll be on a long, bumpy road ahead.
Abroaden is a company for expats, digital nomads and other world citizens looking for low-cost and transparent financial advice and investment management.