Broker Check

The Economy, Earnings, and Stock Prices

May 06, 2020

The economic and financial data reported over the past month has been bad. In some cases, it has been historically bad. Weekly unemployment claims have been higher than at any other time in US history. The US economy contracted nearly 5% on an annual basis in the first quarter and the second quarter data is expected to be even worse given the protracted economic shutdown which may continue for the bulk of the quarter. US companies are reporting weaker earnings, cutting dividends, and lowering their guidance for future earnings. There are few periods in history when the data has been this bad and there is still uncertainty as to how severe the economic contraction will be and how long it will last.

Yet, stock prices have been quite resilient in the face of the poor economic and financial data. Stock prices, as measured by the S&P 500 index, erased approximately one-third of their value from the February 19th high to the March 23rd low as investors responded to the risks imposed by the Coronavirus. However, prices have since rebounded more than 25% and are now down just 13% for the year despite continued negative data. Why has the market rebounded so sharply while the data has continued to deteriorate and economic and financial risks persist?

First, it is important to understand that the stock market is forward looking. This means that investors often price in their expectations about the future. Given the strong stock market recovery it appears that investors are pricing in an economic recovery and a quick rebound in economic activity once workers and consumers are allowed to return to their normal routines. This may include some optimism about new treatments for COVID-19 and the possibility that a vaccine will be available in future quarters. So how do we determine if the market has become too optimistic or if it has accurately priced in the prospects for a recovery?

Second, stock prices reflect an average of investors’ expectations. When the Coronavirus risks first emerged stock prices tumbled as many investors priced in a worst-case scenario. When the data was bad, but still better than the worst case, investors rushed to buy stocks as they reassessed their views of the future. Now investors may be pricing in an optimistic expectation that the global economy will reopen soon, and economic activity may recover quite quickly. Should these expectations prove to be too optimistic then stock prices could reverse course as the optimists in the market reassess their views and seek to reduce their portfolio risk level. On the other hand, should the outlook continue to improve those who are still holding on to more pessimistic expectations may become buyers which could push stock prices higher.

If the economic and financial data is bad, but better than the average investor’s expectations, stock prices could continue to be supported by buyers reentering the market. On the other hand, should the data be worse than the average investor’s expectations there could be a new round of selling which could cause stock prices to take another leg down as the Coronavirus risk are more accurately priced into the market. In other words, economic and financial data for April and May will likely be negative but just how negative the data actually is will likely determine the direction of the market. The economic and financial data does not need to be good for the market to rally, it only needs to be better than is expected by market participants.

Now, the name of the game is not just to assess new data as it is released but also to assess investors’ reactions to the data for an indication of how it either exceeds or falls short of investors’ expectations. For stock prices are more likely to reflect investors’ expectations of the future rather than an objective assessment of the current environment.