What the Stock Market Is Really Saying

Originally published at Project-Syndicate | April 24, 2020

In his 2004 book, The Wisdom of Crowds, James Surowiecki shows that large groups of people typically converge upon better predictions than even the smartest individual. He applies this logic to financial markets, where individual investors collectively determine the prices of stocks and bonds. Insofar as the value of a stock or bond reflects its future cash flows (appropriately discounted), markets are typically considered good predictors of the future.

And yet, we know that the collective wisdom distilled by markets is not always correct. As the Nobel laureate economist Paul Samuelson famously quipped back in 1966, “Wall Street indexes predicted nine out of the last five recessions.”

What, then, are we to make of global equity markets over the past month? Despite rising COVID-19 infections and deaths, sweeping lockdowns, soaring unemployment, and collapsing economic activity, markets have been on a tear. Are they expressing collective wisdom about a better future, or the groupthink of lemmings running off a cliff?


The answer is a nuanced neither. Behind the headlines about surging equity markets, investors are being highly selective, shunning the most economically sensitive sectors, countries, and financial instruments. There is a rush into safe, reliable companies that are likely to fare relatively well in uncertain and risky times. The crowd may be wise, but its judgment doesn’t necessarily bode well for the rest of us.

Despite equity markets’ recovery, global bond yields are hovering near all-time lows. For the first time ever, oil prices have turned negative (meaning that oil is worth less than the cost of storing it), and most cyclical commodities remain under pressure. Moreover, emerging-market currencies have dropped precipitously against the US dollar, and gold prices are surging, which is typically a sign of investor anxiety. All told, the trends across fixed-income, currency, and commodity markets do not suggest that a strong recovery is on the horizon.

Among global equity markets, those in countries such as the United States and Switzerland have suffered the least, because their market capitalizations have a disproportionate number of diverse, large, and stable companies. By contrast, markets in countries more economically sensitive to specific sector dynamics – such as Brazil and Australia in commodities, or Germany in industrials – have fallen by 10-30% more than the S&P 500 in the US. China, meanwhile, has emerged as the world’s top-performing equity market, an outcome that probably reflects its apparent success in containing the pandemic, as well as investor perceptions that its stimulus policies will be more effective than those of, say, Europe.

Investors’ preference for safety is also apparent in which US stocks and investment styles have performed best. During the market rebound earlier this month, health care, technology, and consumer staples handily outperformed industrials, materials, and energy stocks. Similarly, growth and minimal volatility trounced value and small capitalization performance.


All of these developments boil down to a case of the “chosen few.” The share of S&P 500 market capitalization claimed by the five largest stocks in the index has soared to all-time highs, easily surpassing that of the dot-com bubble almost 20 years ago.

The five most valuable companies today – Microsoft, Apple, Amazon, Alphabet, and Facebook – are gargantuan quasi-monopolies, widely regarded as the winners in a world where lockdowns have forced everyone online. This year, they have collectively beaten the broader US market by leaps and bounds. In panicky times, these tech giants gain market share at the expense of their weaker rivals, and they have the kind of huge cash balances that investors love. The top five are so enormous relative to the broader market that their distortion effects easily muddle the overall picture. The market value of just two of these companies, Amazon and Microsoft, is higher than that of the entire FTSE 100.

So, while the recent strong rally in global markets could be seen as a signal that recovery is close at hand, that interpretation would be a mistake. If anything, the “crowd” is telling us that social isolation, uncertainty, and economic peril will persist for longer. A broader market recovery would require a durable resumption of economic activity and a boost to corporate profits well beyond the “chosen few.” That is unlikely to happen for a host of reasons.


For starters, despite the global spread of the pandemic, no country is anywhere close to having built up “herd immunity.” Even allowing for the inevitable errors in measurement, the share of the infected or now-immune population in any major economy probably remains below 10%. More fundamentally, the extent to which infection confers immunity against COVID-19 is itself an open question. With effective antiviral treatments or a vaccination still many months away, any easing of social-isolation measures will likely result in recurring infection spikes.

Indeed, some countries that initially succeeded in flattening the epidemic curve are now experiencing a resurgence of new infections. Singapore tackled the pandemic early and aggressively by providing free testing and treatment. For a time, that response worked. Yet in the past week, its COVID-19 caseload has more than doubled, and the bulk of its new cases appear to be linked to domestic transmission, not foreign arrivals.

Singapore’s experience suggests that even where extensive testing and monitoring are applied with a “flat curve,” new outbreaks can still occur. That is a bad omen for the US, which remains woefully behind when it comes to testing and monitoring for new cases.

Moreover, it is unlikely that firms will rehire workers as quickly as they fired or furloughed them. In the new climate of uncertainty, businesses will await recovery of demand for their goods and services before calling workers back to the job. And it could be a long wait. Consider the restaurant industry, which accounts for approximately 16 million US jobs. The private-equity owner of some of the largest US restaurant chains has indicated to us that it may be two years before they understand their “new normal” and can rehire with confidence.

In the meantime, the ripple effects will be profound. Trucking services will go idle, farms that relied on restaurants to purchase their goods will lose their main revenue sources, and workers without jobs will slash their spending. And even when restaurants are ready to reopen, supply-chain disruptions and lenders’ probable reluctance to extend fresh credit on agreeable terms will make it difficult to do so.


Unfortunately, despite unprecedented government commitments to borrow and spend, rising precautionary savings on the part of households and businesses will blunt the effectiveness of fiscal stimulus. And while central banks have played a critical role by monetizing government debt and financing credit guarantees to business, these measures are only stabilizers; they will not spark fresh spending on their own.

As the March collapse in US housing construction indicates, even today’s low interest rates cannot spur much borrowing and spending when the future remains so cloudy. The private sector’s rush to save has compromised fiscal and monetary policy multipliers (as it did in Japan for decades), and could leave psychological scars that affect consumption habits for a generation to come, as happened after the Great Depression.

Moreover, with growing pressure to “restart the economy,” we are likely to see sawtooth patterns of recurring infections and shutdowns, as the Singapore experience suggests. Here, a key issue will be the lag between the relaxation of social-distancing measures and the emergence of new COVID-19 infections.

Epidemiologists anticipate a 3-4 week delay, which means there could be “quiet periods” during which communities will misjudge the risks and thereby compound the pandemic. Surges of new infections in areas with inadequate health-care infrastructure could prove deadlier than anything we have witnessed so far, triggering even more severe lockdown episodes and exacerbating the economic and financial fallout.

Finally, in a range of emerging economies, the full impact of the pandemic has yet to be felt. But there is little doubt that COVID-19 will devastate many countries, causing major social and economic disruptions and human suffering on a massive scale. In Africa, even before there was widespread reporting on new coronavirus cases, currencies, sovereign debt, and public equities fell further than in developed or other emerging markets. In some cases, African equity markets plunged below the depths reached during the global financial crisis.

To be sure, certain factors may mitigate the risk that COVID-19 poses to African countries. Fully 60% of the continent’s population is below the age of 25. The region also has some previous experience in dealing with epidemics (such as Ebola), and the population may be more resistant to diseases found in tropical or poor regions (such as tuberculosis). However, the region also has sprawling, crowded cities with dense housing arrangements, poor sanitation, and weak health-care systems.

Besides, for the developing world more broadly, social-distancing strategies are physically difficult or impossible to maintain. A significant share of economic activity in middle-income and developing countries is informal and cash-based, requiring close personal interaction. For most people, telecommuting is not an option, nor do governments have the wherewithal to pay people to stay home.


Given all of these considerations, the least likely outcome for the global economy is a so-called V-shaped recovery, wherein a sharp fall in output is followed by an equally rapid return to normalcy. According to the International Monetary Fund’s latest projections, global real (inflation-adjusted) GDP is expected to fall by 2-4% this year. Even if we assume the lower end of that range and factor in only a modest decline in inflation, nominal GDP for the year will fall by at least five percentage points compared to the IMF’s pre-pandemic forecast.

Judging by the past relationship between nominal GDP growth and corporate profits, earnings per share for companies listed on major stock exchanges will likely fall by 10-20% compared to what was expected at the beginning of this year. Instead of 8-10% earnings growth for the S&P 500, market participants should now anticipate no earnings growth, at best, and perhaps an outright decline of 10%. And these figures are based on conservative projections for the damage the pandemic will inflict on global GDP growth.

The forecasters assume that there will be some form of stabilization and recovery in major economies by the end of the year. Yet if we take the view that social-distancing policies will last longer and be recurring, and that monetary and fiscal stimulus will be less effective than expected, earnings could well fall by 20% or more.

Either way, the outlook does not bode well for equity markets. As of February, S&P 500 earnings per share were estimated to be $180 for the year, and the market was trading at a 19 price-to-earnings ratio – 15% above the index’s long-term average valuation. If earnings fall by 20% (to $145) and the S&P 500’s mid-April market capitalization remains at 2,825, investors will be assigning an even slightly higher P/E valuation of 19.5, despite the pandemic.

That should raise eyebrows.

Before COVID-19 arrived, the global growth downturn was showing signs of bottoming out. The US Federal Reserve had returned to monetary-policy easing, the US had agreed to a “trade truce” with China and other countries, and corporate profits were forecast to rebound from a flat 2019. In other words, markets were priced for perfection.

But now, a mere three months later, the world economy is in the midst of a pandemic-induced economic shutdown of undetermined duration and magnitude. Unemployment is soaring toward levels not seen since the 1930s, an effective vaccine or antiviral is at least a year away (after another flu season), oil prices are cratering, and insolvency risk is rising rapidly across the economy.

And yet, despite this parade of horribles, the valuation of the US equity market remains unchanged. The argument that stocks deserve their higher valuations because bond yields have plummeted is not terribly convincing. Stock prices can easily fall when bond yields plunge, as happened in Japan during the 1990s and in the US during the 2008 financial crisis.

It may be true that bonds offer unattractive yields, but that does not change the fact that today’s extremely low interest rates reflect tremendous economic uncertainty and doubts that the world economy can be revived anytime soon. High valuations are not warranted if low bond yields echo dire earnings prospects.

Others argue that stock markets benefit from central-bank asset purchases, which have recently been expanded into non-traditional asset classes like high-yield corporate and municipal debt. To be sure, investors respect central banks’ firepower, and such backstopping of corporate credit likely provides some comfort to equity holders. Nonetheless, neither the European Central Bank nor the Fed is actually purchasing global equities, as the Japanese and Swiss central banks have done in the past.

In fact, Japan’s experience is particularly relevant now. For each of the past five years, the Bank of Japan has purchased ¥6 trillion ($56 billion) worth of equity in exchange-traded funds as part of its quantitative-easing program. And just last month, the BOJ announced that it would double the size of its stock-market interventions.

Yet, despite the BOJ’s best efforts, Japan’s stock-market performance has continued to languish: the broad Topix index has fallen by 17% since the beginning of 2020, underperforming the S&P 500 by 2.5 percentage points. Evidently, Japanese sellers have shown little interest in offloading their holdings to the central bank.

Finally, various government officials, including US Secretary of the Treasury Steve Mnuchin, have suggested that corporate bailouts may come with conditionality. Thus, while shareholders may have some reason to believe that policy support will save them from ruin, it also most likely will come with a price tag.


That brings us to a final critical point. Because the effects of the pandemic are likely to prove long lasting, surging government debt will place enormous future burdens on economies, lowering long-term potential growth. The pandemic has shattered faith in various aspects of globalization, not least long, “just-in-time” supply chains and the lean inventories they allow. A costly reallocation of resources and an increase in “just-in-case” production will inevitably be part of the post-pandemic new normal, with obvious negative implications for future earnings.

As in the aftermath of the September 11, 2001, terrorist attacks, when airports had to implement disruptive security checks, a post-pandemic global economy will require businesses to have back-up plans to cope with the next epidemic or global systemic crisis. Such contingencies will be expensive, and they will not boost revenues. Investors will not be able to ignore the fact that operating a global business will be less profitable in the future than it was in the recent past.

We are pleased to share with you this commentary, which we wrote for Project SyndicatePS is the world’s largest provider of high-quality commentary on the most pressing issues of the day, including the latest pandemic-related developments. 

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