How can markets hit new record highs when the economy is in such a mess?

Despite the world being in the midst of a global pandemic, America's Nasdaq stock index just hit an all-time high. And it's not the only index on a bull run. John Stepek explains why markets and the real world often seem to be at odds.

Turns out that US employment figures for last month were a good bit better than expected. The monthly non-farm payrolls data was released a day early, because of America’s Independence Day holiday this weekend.

Hard as it is to believe, 4.8 million jobs were added to the US economy in June, compared to economists’ expectations for three million.

Does this spell a V-shaped recovery? Is the data reliable? And does any of it really justify new record highs for stock markets (in the US at least)?

A 25% gain on a global pandemic? Stranger things have happened

Employment figures for the US beat expectations soundly when they were released yesterday. Unemployment was down from 13.3% to 11.1%. The underemployment rate fell too, from 21.2% to 18%.

Now, as plenty of people were quick to point out, you have to take this with a pinch of salt. Weekly jobless claims are continuing to rise, which suggests that the recent resurgence of Covid-19 in many states might be having an effect on plans to end lockdowns.

Nevertheless, markets were still cheered by the news. The tech-heavy Nasdaq index in the US managed to hit a new record high.

Let me be clear, in case you didn’t know. That’s a new all-time record high. It’s not a new “since-coronavirus” high. It’s a level that’s never been seen before, above 10,200.

Just to hammer that home, think about this time last year. Back then all of our market worries were somewhat vague ones about Chinese trade wars. In Britain, our thoughts were mostly taken up with Jeremy Corbyn and Brexit.

This time last year, employment across the world was at record levels. Economies were still growing – maybe not as fast as everyone wanted, but they were growing.

Well, this time last year the Nasdaq was sitting at 8,170. In other words, it has risen in value by about 25% since then.

If you’d bought the Nasdaq in July 2019, gone to sleep for a year, and woke up and looked at your portfolio this morning, what would you think? I suspect you’d think that things were pretty hunky-dory. You’d probably think – “oh I guess we’re pals with the Chinese and that Brexit is done and dusted”.

You probably wouldn’t think: “Gosh, I bet you there’s been a global pandemic during the time I was asleep, that’s the only possible explanation for a 25% rise in the Nasdaq during that time”.

The stockmarket is not the economy; the economy is not the stockmarket

So believe me, I get it. I see why people are finding it hard to understand why markets are as high as they are, even given tentative signs that things are “sort-of, maybe” getting better.

But it goes back to this very important thing that we say a lot at MoneyWeek: the economy is not the stockmarket. It’s extremely counter-intuitive. I need to repeat it constantly to remind myself. The economy and the stockmarket are two very different things.

The two are related in theory, obviously. Companies are part of the economy. Decent economic growth and solid employment levels should, in theory, mean decent earnings growth, which should mean higher share prices, so overall, they should reflect each other in the long run.

However, on a day-to-day basis this relationship is so distant that you might as well ignore it, certainly at the “big picture”, “how much did GDP fall by this quarter?” level.

There are lots of reasons for this. These days, the domestic economy doesn’t necessarily count for a great deal to companies which are listed in any given index. In the FTSE 100 (or the S&P 500, for that matter), the level of revenues that any given company generates in the UK (or the US) may be tiny or even non-existent.

Also, there’s a huge time lag between the two. You get economic data in hindsight – by the time you read it, it’s old news (very old news if you’re talking about GDP figures).

Markets, by contrast, are about pricing in probable future scenarios. Clearly, that often involves simply extrapolating the past, but the point is that markets are forward looking, whereas economic data is backward looking.

That’s why the market rarely reacts to some of the most headline-grabbing statistics. Newspapers will shriek from the rooftops that GDP fell by 20% last quarter, say. But the market couldn’t care less by that point because it’s already happened.

Finally, and probably most importantly, money-flows matter an awful lot to markets, and the economic data doesn’t necessarily dictate those money flows. So when you have bad economic news, but you also have central banks opening the floodgates as a result of that news, you’ll often see markets go up.

When you look at it with all of this in mind, then it starts to make sense. It’s still hard to wrap your head around it, but at least there’s a rationale there. Central banks have splurged so much money into the economy that it feels as though there’s little choice for stocks but to go up.

It’s true that the economy faces some terrible challenges ahead. And there’s lots of room for disappointment as companies report their results with grim faces in the months ahead.

But so far, governments and central banks show no sign that they’re going to pull back. Frankly, that’s what I’d be looking for if you’re worried that markets are going to crash back down: a withdrawal of stimulus.

As that seems unlikely, I wouldn’t be surprised to see markets continue higher. So stick to your plan. Don’t be bamboozled by the apparent disconnect between reality and the markets. A melt-up is at least as likely as a meltdown from here.

And subscribe to MoneyWeek magazine if you don’t already – six issues free, right here.

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