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August 23, 2020

What’s Up with Stocks?

Almost every casual conversation I have about the economy turns to the stunning recovery of the stock market. From investment professional to anxious observer, few can reconcile a Great Depression level of unemployment and GDP declines with the resurrection of stock markets that took place since the crash of March 2020.

Now, I don’t wish to pretend I can forecast stocks or fully explain why they’ve recovered. If I could predict the stock market 60 percent of the time, I’d be among the richest men in the world in just a few weeks. What I can do is offer some reasonable causes for the wild swings and nearly full recovery we’ve experienced over the past six months.

To begin, I’ll have to share some too infrequently spoken truths about stock markets. The first is simply that stock markets exist to match household savings with investment opportunities. This is what all financial services do, and stock markets are especially good at it.

For all the convenient critiques of Wall Street as a place for rich people, most American families own stock. If you have any retirement fund, at any time in your life, you are a Wall Street investor. You may pick stocks yourself or, like my family, let a fund manager pick them. Either way, you are a capitalist. In fact, we are nearly all capitalists now. That is news to celebrate, because the future will require the economic growth that only capitalism can deliver.

The stock market is important for other reasons. Many nonprofits and nearly all philanthropic organizations rely upon stock returns. That means everything from youth sports to anti-poverty programs to scholarships rely on the growth of wealth delivered by stocks. My church, like most, funds missions and youth programs from stock investments. There is no good alternative, and we should be enormously thankful that we enjoy well-functioning markets where we can buy and sell small parts of companies, the things we call stocks.

With stock markets serving this important societal service, it would be too much to ask that they also be good measures of overall economic performance. All we can expect is that prices of stocks will signal where the best investment options lie. That is profoundly important, and gives us some insight into why stock prices recovered from the March crash.

In the wake of COVID-19, the Federal Reserve cut interest rates, flooded financial markets with cash by purchasing bonds and bought private sector debt. This is consistent with their legal mandate set in 1947 to keep inflation and unemployment low. The goal of these policies was to push money into more productive activities thus reviving the economy.

So, Fed policies meant that bank deposits had very low returns, causing some households to move money to stocks. It also pushed bond yields negative after adjusting for inflation. Bond markets are where governments go to borrow cheaply, and pushing them into negative territory caused some investors to move to stocks.

These policies are far from perfect, but they tend to restore confidence in the economy, and explain at least part of the stock market recovery. In other words, stock markets recovered because they offered the least bad haven for those with savings.

Another explanation for the stock market resurgence is the limited nature of early economic damage from COVID-19. Some corporations listed in stock markets faced early losses, such as Disney and United Airlines. But, most of the economic damage of COVID-19 has fallen on smaller companies, such as independent restaurants and bars. Local government, schools and universities also faced significant employment cuts. None of these are represented on stock exchanges. That doesn’t mean stock investors don’t care about this part of our economy. Eventually lost employment in small firms and government will put major downward pressure on stock prices. But we are only six months into a multi-year downturn, and the fullness of this downturn is ahead of us, not behind us. 

The stock market isn’t just affected by the absence of small firms on its listing. The shifts in household and business consumption that accompanied the early stages of the pandemic benefitted some of the largest firms on the listing. Large technology firms, such as Apple and Google, profited from us working at home as we bought new equipment, software and online services. The fancy yoga pants and gallon-sized jars of hand sanitizer were delivered by Amazon, whose stock prices are up by 40 percent since the start of the pandemic.

Stock market indices are not linear combinations of listed firms; they are weighted by firm value, so the big firms that did best in the pandemic swamp the smaller firms, such as airlines or hotels. Even Disney, which saw its theme parks close, recovered as its streaming services replaced its lost profits.

Link to this commentary: https://commentaries.cberdata.org/1070/what-s-up-with-stocks

Tags: capitalism, economic theory, profits, stocks and investment, united states of america, covid


About the Author

Michael Hicks cberdirector@bsu.edu

Michael J. Hicks, PhD, is the director of the Center for Business and Economic Research and the George and Frances Ball distinguished professor of economics in the Miller College of Business at Ball State University. Note: The views expressed here are solely those of the author, and do not represent those of funders, associations, any entity of Ball State University, or its governing body.

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