Has the equity market decoupled from economic reality?

The COVID-19 pandemic has left the world economy in tatters, but the (US) equity market hit a new all-time high in early September. Is this a classic case of “irrational exuberance”, or could it be a signal that the economic outlook is much better than generally assumed? The latter supposition is rather unlikely to be true, so ultralow interest rates remain one of the main arguments and drivers behind the share-price boom. However, a bull market that depends primarily on monetary policy accommodation is a problematic one.

Equity Market ≠ Economy…

A pandemic, the sharpest economic contraction in the modern era, spiraling public debt, …  – the year 2020 has already entered the annals of history as an annus horribilis. And after economic activity had just begun to recover in fits and starts from the initial coronavirus lockdown, it is already getting steamrolled again at the moment by a second wave of contagion. Economic output doesn’t look set to return to the pre-crisis level before the end of next year and perhaps even much later than that. Growth prospects thus certainly have not improved compared to the pre-crisis expectations. This makes it all the more surprising that the USA’s S&P 500 index hit a new all-time high a few weeks ago. Is this a classic case of “irrational exuberance”, or could it be a signal that the economic outlook is much better than generally assumed?

Finance theory teaches that stock prices should reflect the discounted long-term future stream of expected dividend payouts. Those payouts, in turn, should correlate with corporate earnings growth, which one would expect to stand in close relation with underlying economic conditions. Hence, although stock prices often deviate considerably from the economic fundamentals in the medium term, one should definitely expect to see a certain long-term correlation between equity-market performance and economic growth.

Equity market vs. economy
A certain correlation

Gross domestic product and equity-market return

Sources: BCA Research, Kaiser Partner Privatbank

In real-world practice there is indeed a loose correlation interspersed with occasional big deviations. The accent here, however, is on “loose” because there are several points to bear in mind when comparing stock-market performance and economic growth, taking the USA as an example in this instance:

• The equity market represents only shares of companies that trade on a securities exchange, whereas gross domestic product (GDP) also includes the economic output contributions from the rest of the private-sector economy and the public sector.
• Many US companies earn a sizable part of their profits abroad. Those foreign earnings do not depend on economic activity in the USA.
• The sector composition of the equity market (S&P 500 index) differs (significantly) from the business makeup of the overall economy.
• The price performance of stocks can reflect large valuation fluctuations that are determined more by investor sentiment than by the economic fundamentals.

An analysis of at least the first two points doesn’t deliver any arguments in support of the notion that the stock performance of large publicly traded companies can lastingly decouple from macroeconomic activity. The corporate share of gross domestic product in the US example has held relatively steady over the last few decades, and corporate revenue has risen and fallen in line economic activity. Profits earned abroad, which account for almost 50% of total corporate earnings, likewise do not deviate significantly over extended periods from profits made in America and thus cannot serve as an explanation for a decoupling of stock prices from the real economy.

The situation concerning point 3 is not quite as straightforward: the sector composition of the equity market (taking the broad S&P 500 index as an example) deviates significantly in some industries from the respective sector contributions to gross domestic product. The same goes for sales revenue and earnings. The technology industry, for example, accounts for just 3.4% of the corporate sector’s aggregate GDP generation, but makes up a good quarter of the total weight of the S&P 500 index and accounts for a very disproportionately large share of revenue (11.2%) and earnings (21.8%). This huge discrepancy, particularly viewed in combination with point 4 and the valuation issue, is part of the answer to the question of why stock prices in the medium term can sometimes trace out big up and down movements that are not reflected in the real economy.

Equity Market ≠ Economy
Major discrepancies

Comparison of sector composition of S&P 500 and sector contributions to GDP

Sources: BCA Research, Kaiser Partner Privatbank

Is the equity market overvalued?

This seemingly simple question actually isn’t all that easy to answer because there is a wide spectrum of methods and metrics for valuing stocks. If we look at “classic” metrics based on corporate earnings – such as the price-to-earnings ratio, for example –, they currently indicate that the equity market is on the “expensive” side. The same goes for metrics like price-to-sales, price-to-book value and equity market capitalization-to-GDP ratios. But even when those ratios are adjusted to strip out the extraordinary performance of the technology sector, the market is still “priceyish”.

However, the equity market looks far more attractive when one compares the dividend or earnings yields of stocks with the meager yields that bonds and the overnight money market currently offer. The argument from this perspective is TINA, the acronym for “there is no alternative.” Rare is the (institutional) investor who can eschew stocks when they are delivering a bigger (dividend) yield than even 30-year government bonds are. During the equity bubble at the turn of the millennium, there was a five-percentage-point yield differential in favor of bonds, making them clearly the superior alternative. But the situation looks different these days. The US Federal Reserve projects that the benchmark US federal funds rate will stay close to 0% until at least the end of 2023. This means that the age of no alternatives looks set to last quite a bit longer.

Lofty valuations…
…are not solely a tech phenomenon

Valuation ratios for S&P 500 subsectors

Sources: BCA Research, Kaiser Partner Privatbank

How is the economy doing?

Stocks should be a long-term financial investment, so it makes sense to frame the valuation issue in a context that factors in the long-term economic outlook. Nevertheless, short-term fluctuations in economic activity influence investor sentiment and thus cannot be ignored. A certain degree of disillusionment about the near-term outlook has arisen in recent weeks. The US economy’s rebound from the initial coronavirus shock has noticeably plateaued lately. Meanwhile, a further urgently needed COVID-19 relief package is currently stuck in Congress. A second wave of contagion like the one already observable in Europe right now is also possible in the USA, and hopes that a vaccine will soon be available could end in disappointment. All in all, the economic outlook for the near to medium term remains fraught with considerable uncertainty. In any event, it will probably take the US economy at least until end-2021 to claw its way back to its end-2019 GDP level. The pandemic, however, poses downside risks to this forecast.

The longer-term outlook for the (US) economy is also uninspiring, as it already was before the onset of the coronavirus crisis. The two long-term growth drivers – demographics and productivity – have been pointing downward for quite some time now. The demographics math is simple: falling birth rates look destined to constrain the annual growth of the working-age population to just 0.2% this decade (compared to over 1% in previous decades). Even that number could prove overly optimistic if the rampant antipathy toward immigration further escalates. An aging population adversely affects an economy’s growth potential. It does so directly by slowing the expansion of the workforce as well as indirectly by causing rising healthcare costs and deteriorating public finances that eventually have to be funded by higher taxes, which brake economic growth.

The issue of productivity is more controversial because it is relatively hard to measure and forecast. It’s an undisputed fact, however, that the US economy’s output per hour worked has hardly increased at all in recent years. This flat trend is unlikely to change much in the face of the coronavirus restrictions. Although the stepped-up trend toward working remotely may result in some productivity gains here and there, at the same time, the pandemic is accelerating the tendency toward deglobalization, and various new health-related safety protocols in some industries likewise are exerting a damping effect on productivity. Continued muted investment in new capital goods and increasing state interference in economic life are equally detrimental to productivity growth. On the whole, there are some positive but also a few more negative factors that will affect future productivity gains. However, all forecasts should be treated with caution, so in the best case one should envisage moderately positive productivity growth rates going forward.

The bottom line for investment strategy

There are plenty of approaches to explaining the strength of the equity market in spite of the dimmed economic prospects. Explanation number one is the US Federal Reserve’s ultra-accommodative monetary policy, which is prompting investors to increasingly take on more risk in their investments. Combine this with the recent burst of technology-sector euphoria, which at least in some subsegments is reminiscent of the tech bubble seen at the turn of the millennium. And finally, even the pandemic itself is being held responsible in some instances for the strong stock-market performance in coronavirus times because it has encouraged many a bored (novice) investor to speculate on trading platforms like Robinhood. What’s missing from this list, though, is a robust economy to justify the current valuation levels. In any case, given the near- and long-term outlooks described above, it appears implausible that corporate earnings will grow fast enough over the next five to ten years to lower stock valuations to more moderate levels.

Altogether, we can conclude that the equity market indeed appears to have decoupled from the economy to some degree. This divergence could persist for a long time, true to the adage that “the market can stay irrational longer than you can stay solvent.” If the equity bull market is being driven mainly by the TINA argument, then its end isn’t necessarily in sight yet. However, such a decoupling is unlikely to be sustainable because stock-market history also teaches that economic fundamentals eventually always do matter at some point. An investment strategy based solely on TINA is likewise not sustainable. Nevertheless, we, like everyone else, have to work with the investment climate that surrounds us, and right now it’s an environment in which (almost) every asset class is richly valued. Our medium-term cyclical outlook for stocks therefore remains constructive. The challenge will be to adjust our stance with the right timing and to jump off the bandwagon at the right moment. In the meantime, good portfolio diversification remains a core element of our investment strategy and provides protection against inevitable market volatility. An increased allocation to alternative assets and employment of hedging strategies as needed are also integral elements of modern, prudent portfolio management, in our view.

No alternatives?
The TINA argument

S&P 500 dividend yield and 10-year US Treasury note yield

Sources: BCA Research, Kaiser Partner Privatbank