The Disconnect Between the Stock Market and the Economy
![Stock Market display](https://s33007.pcdn.co/wp-content/uploads/2019/10/stock-market-display.jpg)
As May has progressed, so has disbelief of the disconnect between equity markets and the broader economic reality that is unfolding. It’s now front page news with a variety of articles popping up detailing this dynamic (examples here, here, and here) speaking about this growing disconnect, and offering similar explanations for why this is occurring…
We largely agree with each of the above points at a high level. However, we offer a more nuanced view. We believe that we are in the process of resolving the interplay between forces that have shrunk left tail outcomes (policy response and continued strong performance from key portions of the “new economy”) and those that cap right tail (scientific uncertainty relating to health outcomes during reopening, behavioral impact to consumers, and emerging valuation constraints).
A comment Jerome Powell made in his last press conference really jumped out to us. On April 29th Powell said, “The second thing I would say, you have all seen this, is when we announce these facilities, I mentioned in my remarks it’s not just the actual lending we do. We build confidence in the market, and private market participants come in, and many companies that would have had to come to the Fed have now been able to finance themselves privately, since we announced the initial term sheet on these facilities. That is a good thing.”
Confidence is returning markets to normal function. Issuance has resumed, spreads have tightened, and financial conditions are back near early-March levels. This is the communication tool writ large. It is working as intended.
This also means that two-way trading will not elicit a bazooka policy response moving forward. A system functioning normally includes episodic volatility and the Fed will not be concerned about transitory downside events (that don’t disrupt the credit creation process). The market, in our opinion, has become a bit too casual about this.
We make two points here:
This is best expressed in relative terms – our affinity for “growth,” “size” (Large > small), and US vs Row is well established. This lends itself to a structurally positive index direction given the “large bodies” these themes represent in current index construction. However, with a market that is struggling with further upside progress it is important to note that these themes are not immune to weakness in an absolute sense. If our broader index outlook proves accurate, we will enter a period where the denominator will begin to do the work (i.e. QQQ moves lower but QQQ/SPY moves higher). For long/short participants it is imperative to be paired up here. For long-only participants, the message is that weakness from here will be opportunity. These are the themes to engage with into volatility but there is no need to reach at current levels.
In sum, our high-level views remain unchanged. The market is in the process of establishing the high end of what will prove to be a wide/well-traveled range. It is increasingly likely that the highs from April 29 will define the high end while the initial downside focus remains on the key 2650 area. The market vs economy disconnect will begin to resolve and be most pronounced in an unwinding of the recent performance of economic beta with cyclicals and small caps the most vulnerable areas of the market moving forward.