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By Ian Riach and David Andrews, Franklin Templeton Canada
(Sponsor Content)
Equity markets that bear little resemblance to the wider economy has been one of the major investment stories of 2020. It has been an historic year, marked by some wild swings in stock valuations, and with the prospect of much more volatility to come. The U.S Presidential Election in November looms large on the horizon, not to mention the small matter of COVID-19.
The coronavirus has devastated the world economy; in its most recent forecast, the IMF predicted a global economic contraction of 4.9% for 2020. To put that number in perspective, such a downturn would represent the worst annual decline since the Great Depression of the 1930s.
Equity markets tell a different story, and stocks have rallied strongly since the bear market lows of March this year. In fact, U.S. equities reached record highs with the S&P 500 up more than 21% on a one-year basis at the end of August.
This disparity has brought the relationship between stocks and the overall economy into sharp focus in 2020. While both the U.S. and Canada posted some positive job numbers in August, unemployment remains high (10.2% in Canada; 8.4% in the U.S.) and the stimulus measures that kept the economy afloat during the lockdown will not continue indefinitely. Then there is the virus itself to consider, particularly the threat of a second wave that is even more devastating than the first, which is what happened with the Spanish Flu of 1918–1920.
The economy is precarious
The economy is clearly in a quite precarious position and some areas (tourism, hospitality, air travel) could take years to recover, if at all. It does seem logical to presume that stock market performance and economic conditions should go hand in hand — economic growth resulting in higher corporate profits and in turn, higher share prices.
Often that is not the case, with a low, and sometimes even negative, correlation between stock market returns and GDP throughout history. Despite Donald Trump’s assertion that everything is fine when the stock market goes up, the stock market is not the economy.
Stock markets, represented by indices such as the S&P 500, are comprised of a very select group of firms that are publicly traded. Most indices are market cap weighted, which means larger firms have more of an impact on overall index movements — think of the FAANG (Facebook, Amazon, Apple, Netflix and Google) stocks and their influence this year.
The chart above displays just how influential large stocks can be on an index. Year to date, the S&P 500 has a positive return but only because of strong returns by the FAANG stocks. The ‘other 495 stocks’ have not fared nearly as well as the index would imply. It is clear that a few companies have benefitted from the fallout of the COVID-19 pandemic, but most have not. Continue Reading…
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