What is going on? Our GDP has collapsed and 16 million people are unemployed. Thousands of small businesses and dozens of billion-dollar companies have gone bankrupt, including California Pizza Kitchen, Hertz, JCPenney, Neiman Marcus, and Brooks Brothers. Yet, the stock market keeps hitting all-time high after all-time high.
The stock market is supposed to be related to the economy. When the economy booms, corporate profits explode; when the economy collapses, profits crater. That’s what happened during the Great Depression when stock prices fell 90 percent and the unemployment rate averaged 19 percent for a decade. Now, stocks and the economy are moving in opposite directions. What is going on?
A friend who knows that I live, breathe, and teach investments gave me a suggestion that inspired me to write this article:
Why don’t people use AI to find out why the market’s booming while the economy is tanking?
This innocent question reminded me of the experience of Charles Babbage (1791–1871), the “father of the computer”:
On two occasions I have been asked [by members of parliament], “Pray, Mr. Babbage, if you put into the machine wrong figures, will the right answers come out?”… I am not able rightly to apprehend the kind of confusion of ideas that could provoke such a question.Babbage, Charles (1864). Passages from the Life of a Philosopher. Longman and Co. p. 67. OCLC 258982
I, too, am struck by the confusion revealed by my friend’s question. I started laughing before I realized that he was not joking.
I am also reminded of when I was a graduate student in the late 1960s using a large mainframe computer to estimate the parameters of a complicated economic model. My wife’s grandfather (“Popsie”) had bought and sold stocks for decades. He even had his own desk at his broker’s office where he could trade stocks and gossip. Nonetheless, he wanted advice from me, a 21-year-old kid who had no money and had never bought a single share of stock in his life, because I worked with computers: “Ask the computer what it thinks of Schlumberger.” “Ask the computer what it thinks of GE.”
Computers don’t think about Schlumberger or GE. They don’t think at all. They compute.
I could certainly write an algorithm that would sift through thousands of different variables calculating the hypothetical returns from random trading strategies. But that wouldn’t be thinking. The algorithm’s calculations might show that buying stocks with low price/earnings ratios would have been profitable in the past. Its calculations might show that buying stocks with ticker symbols that begin with the letter J would have been profitable. But the algorithm wouldn’t know in any meaningful sense what stock returns, price/earnings ratios, or ticker symbols are, let alone why they might or might not be related.
In the same way, computer algorithms can’t tell us why the stock market is booming while the economy is tanking. Again, I could write an algorithm that would sift through thousands of different variables looking for some that might be positively correlated with the market and negative correlated with the economy, or vice versa. But the algorithm would not know what any of the correlations meant, let alone whether they made sense.
Letting an algorithm loose on Donald Trump’s tweets, I recently found that the word president was positively correlated with the S&P 500 two days later, that the word ever was positively correlated with the low temperature in Moscow four days later, and that the word with was negatively correlated with the stock price of a Chinese tea distributor four days later. The algorithm had no way of knowing that this was rubbish. It didn’t think, it computed.
So, why is the market booming while the economy is tanking? Instead of asking a computer, I asked a human—myself. Here is my opinion:
Stock prices are certainly affected by the economy but in a very special way. Stock prices reflect investor expectations about the future. This means that there is no reason for stocks to rise or fall when something that is expected to happen does happen. Instead, stock prices are buffeted by surprises. Surprises are, by definition, impossible to predict which makes future changes in stock prices nearly impossible to predict. We might understand, after the fact, why stock prices moved even though we could not have known beforehand that they would move.
We can now say that the market collapsed in February and March because of fears of long-lasting damage to the economy inflicted by COVID-19, though it would have been hard to predict those fears in December or January. When Congress and the Fed reacted quickly, those fears of long-run damage eased. Investors who anticipated such a strong response were rewarded; others were surprised. (In the 1930s, the Congress and Fed did all the wrong things: cutting spending, raising taxes, reducing the money supply, and getting into a trade war, which is why the Great Depression lasted a decade, until the economy mobilized to fight World War II.)
Stock prices are also buffeted by what Keynes called “animal spirits,” which are pretty close to being unpredictable too. The dot-com bubble now seems obviously irrational but, at the time, it was hard to see it for what it was, and even harder to predict when the madness would end. Today, there is strong momentum in many stocks, but it is hard to know if it is irrational and, if it is, when it will end.
This is why, looking forward, I don’t know which direction stock prices will go today, tomorrow, or over the next several weeks. Anyone who says they know is either fooling themselves or trying to fool you.
However, I can explain why stock prices are up while the economy is down. Let’s compare three potential ten-year investments: short-term Treasury bills, long-term Treasury bonds, and stocks. As I write this, the interest rate on 3-month Treasury bills is 0.10 percent, the interest rate on 10-year Treasury bonds is 0.69 percent, and the dividend yield on the S&P 500 is 1.72 percent.
I don’t know if the economy will recover fully next year or the year after, but I am confident that, ten years from now, the economy will be much stronger than today, with far higher corporate profits and dividends. If so, stock prices should be much higher, too, and the annual return from a 10-year investment in stocks will be far above the 1.72 percent dividend yield, and certainly even farther above the meagre returns from Treasury securities.
My answer to the question of why the stock market is booming while the economy is tanking is: (a) stock dividend yields are well above the interest rates on Treasury securities; and (b) looking past the next few months or years, the economy will be much stronger than it is now and stock prices will be much higher, too. Stock prices are high today because, even at these seemingly high prices, stocks look like a good long-term investment compared to the alternatives.
You can question my assumptions, debate my reasoning, and disagree with my conclusions. That’s what humans do because—unlike computers—we are intelligent.
If you enjoyed this piece by Gary Smith, you might also like some of his others:
Stocks are not a Ponzi scheme and here’s why not: It is not the absence or presence of dividends that determine whether a stock is or is not a Ponzi scheme. It is the absence or presence of real profits.
The stock market: Gains, pains, and panics A fear that, if prices fall, they will continue falling is not justified by history but by panic.