The market/economy disconnect may be less extreme than you think
The market/economy disconnect may be less extreme than you think
For weeks the prevailing narrative has been that US equity markets are completely detached from the economic reality on the ground. The US economy has slumped while markets have rallied.
We have offered several explanations for this disconnect, the main one being that markets are forward-looking whereas economic data is backward-looking.
However, these headline numbers mask the significant dispersion between winners and losers across different sectors of the stock market. Also, importantly, they mask that the stock market winners are a relatively small part of the economy whereas the stock market losers matter disproportionately more for the economy.
During the pandemic, the immense strength of the largest sectors in the stock market has offset the weakness in smaller ones. This has created an impression that markets are not in sync with the economy, when in fact the two are more closely aligned than is widely believed.
Which sectors have trailed the market rally?
Although the sell-off earlier this year was indiscriminate, the recovery has seen more of a pattern emerge.
For example, IT and consumer discretionary stocks, accounting for roughly 34% of the S&P 500 Index, are up 12% and 6% respectively this year. Meanwhile, energy and financials stocks, which account for only 16% of the S&P 500, are down 34% and 22% respectively, as shown in the chart below. Although their sector-level performance has been awful, their relatively lower index weights mean that the overall market impact has been more muted.
This makes economic sense. The sectors that have seen demand for their services increase have as a consequence held up much better in stock market terms.
In contrast, those hit particularly hard by the crushing economic slowdown in 2020 have seen their market values plummet. For example, financials have come under pressure over increased fears of loan defaults. In addition, as well as having to deal with slumping demand, the energy sector has been badly affected by an oil price war.
All of this is to say that the market is not as rosy as people may believe.
How important are the stock market winners and losers for the economy?
The irony is that the stock market winners are a relatively small part of the economy, whereas the stock market losers matter disproportionately more.
For example, the IT sector makes up 24% of the S&P 500 but its 2019 revenues were only 6% of US GDP. In contrast, the financial sector makes up 12% of the S&P 500 and its revenues were 8% of US GDP. This mismatch in weightings has contributed to the disconnect between the market and economy.
What are the implications for investors?
The immense dispersion across sectors has underscored the importance of sector allocation decisions in the current environment. Overweighting a particular sector could have either been very profitable or costly for investors.
To illustrate this, we take the excess returns of every stock in the market index (stock return minus S&P 500 return) and calculate their volatility as a measure of “stock dispersion”. We then apply the same methodology for sector excess returns. The ratio of the two is shown in the chart below, which quantifies whether there is more stock or sector variation in excess returns.
On average, stock excess returns are around 2.7x as volatile as sector excess returns. But recently this measure has fallen to under 2x, indicating that the portfolio rewards have been below-average for stock-picking compared to sector-picking.
If history is any guide though, such periods tend to mean-revert and precede significant increases in stock dispersion, as happened in the aftermath of the 2000 and 2008 market crashes. This may be because beaten-down stocks tend to rally significantly once economic conditions improve, while the more defensive, expensive stocks are already priced to perfection, thus creating an opportunity for skilled value investors to exploit.
What’s next for markets?
The notion that the US market has turned a blind eye towards economic fundamentals is less extreme than you think. While no equity sectors were spared from the sell-off, the market rally has been relatively dispersed, with more laggards than leaders.
Yet this effect will not be captured at the market level because indices are biased towards the largest sectors, which have held up relatively well. There is nothing wrong with this per se, it is just a symptom of how market-capitalisation weighted indices are constructed.
Investors that placed their bets on the right sectors may have been recently rewarded. However, once the economic recovery arrives, it looks like they will need to shift gears into stock-picking mode.
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