Broker Check

Are the financial markets disconnected from the real economy?

| May 15, 2020

After a historically bad jobs report last Friday showing 20 million jobs lost and 14.7% unemployment, it is hard to avoid news stories questioning how the stock market could be up over 1% on the day. In fact, the Nasdaq index, heavy with technology stocks turned positive for the year. The Nasdaq has gained 34% from its low point in March.

All this seems to grate on the nerves of a public trying to make sense of a 2 month pandemic caused lockdown, a constant stream of bad economic news and a muddled outlook on how we as a society can move back toward some sense of “normal.”

It is hard to rationalize how the stock market could drop almost 40% in 5 weeks between mid February and mid March and then gain back almost 30% from the lows while the news seems to be getting worse, especially the job losses and the economic damage. 

One explanation is the Efficient Markets Hypothesis. This theory has 2 parts: first, that public information is reflected immediately in asset prices right away, and second, that in efficient markets there are no arbitrage opportunities. This means that since our markets are free, they immediately adjust for all the data available at any given time and because of that it is impossible to profit from news because the markets have already priced it in before we can react.

In late February and March the data on the virus and the effect it would have on our economy was coming quick and fast and markets adjusted for the news at light speed. The fall in stock prices from record highs was the quickest and most dramatic since 1987. Investors sold first and asked questions later.

So what’s changed since March 23rd, when the stock markets were at their lows for the year?

First, the Federal Reserve has acted aggressively with interest rate cuts to zero, bond buying programs for treasuries, corporate and municipal bonds. It is almost impossible to estimate the impact that the Fed has on markets when it comes with trillions of dollars of support.

Second, the data on the virus has gotten less bad. The loss of life and illness is still staggering but efficient markets look at the rate of change in the data to anticipate what the future might bring. This is a “second derivative” effect; the rate of change is becoming less negative, and markets move on these effects.

Another “second derivative” effect is that weekly unemployment claims, while still in the millions, are also starting to slow. Without doubt 2.9 million claims is still horrible, but it is less than half of what the claims were a couple weeks previous. Slowing claims is another sign that things are getting “less bad”. Markets are anticipating that eventually the job market will get better as economies gradually reopen, people get back to work, demand for products increases and workers who have been laid off get hired back.

Efficient markets are constantly evaluating millions of data points, not just the couple ones above. But are markets getting ahead of themselves? Should they reflect what things look like “on the ground” right now?

Historically that isn’t always the case. In March 2009, in the midst of the Great Financial Crisis, the stock market bottomed and started to go up. However, the unemployment rate due to the recession caused by the crisis was still increasing. Unemployment didn’t actually peak until October 2009 at 10%, but the stock market gained dramatically from March 2009. The S&P 500 bottomed at 676 in March 2009 and had gained to 1,036 by the end of October 2009. That is a 53% gain from the low, all while unemployment was still increasing and the economy recovery from the crisis was still very tentative.

Markets are forward looking, whether that seems right or not. Markets were looking forward to the economic damage from the virus when they dropped dramatically and now are looking forward to a recovery. Will it be a U, a V, a swoosh or some other shape? It seems likely to be a long process to get back to normal. But there are reasons for optimism and that is the message I take from the market activity of the last few weeks.

Stay safe, stay healthy and think positive.

The views stated in this letter are not necessarily the opinion of Cetera Advisors LLC and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein.  Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed.  Past performance does not guarantee future results.