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What explains the widening gap between Wall Street and Main Street?

What explains the widening gap between Wall Street and Main Street?
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A common refrain today is that U.S. equity markets do not accurately reflect economic reality. Even as the initial estimate of second-quarter GDP indicates a 9.5 percent contraction (32.9 percent on an annualized basis), major stock market indices continue to surge towards record highs. The rapid stock market recovery from the bear-market low (set on March 23) has flummoxed many. Unemployment rates are in double digits, and the fragile economic recovery appears to be faltering. And, yet, bullish sentiments continue to prevail. So, what explains the widening gap between Wall Street and Main Street? 

It is tempting to presume that economic growth should be closely related to stock market performance. The rationale being that stronger economic growth causes a spike in corporate profits, which in turn boosts earnings per share and supports higher stock prices. Despite this appealing logic, empirical research in recent decades has established that there is no clear relationship between economic growth rates and stock market returns. Indeed, cross-country studies suggest a low or even negative correlation between real GDP per capita growth and inflation-adjusted stock returns. Seasoned financial market observers have long been aware of such a disconnect between stock market performance and overall economic activity. However, the widening disconnect between financial market performance and the real economy observed in the post-2008 period has been somewhat mystifying. The stock market performance during the pandemic has also been quite puzzling

In the past, explanations for the disconnect focused on such facts as the dominance of the stock indices by large multinational companies, the forward-looking nature of equity markets, the tendency for investors to get ahead of themselves and bid-up stock prices on the basis of high expectations for future growth and the relative significance of firm-specific performance metrics (earnings per share) vis-à-vis economy-wide corporate earnings. Multinationals (which account for the majority of large-cap stocks) rely on fast growing regions of the world for growth, and, consequently, their equity performance is often decoupled from the performance of mature domestic economies. Another explanation relates to the forward-looking nature of equity markets. Stock prices, in so far as they reflect the present discounted value of the future stream of earnings, are likely to mirror expectations regarding future GDP growth rates rather than contemporaneous economic performance.

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The disconnect between equity returns and GDP growth rates is also caused by the propensity among investors to prematurely bid up stock prices based on high growth expectations, which reduces future realized gains. The growth rate of economy-wide earnings can also be distinct from the growth rate of earnings per share that current investors receive. This might be due to factors such as new enterprises and privately-held companies contributing more/less to economic growth than existing publicly-listed companies, and, the extent of net buybacks (stock buybacks net of new share issuance) diluting/boosting the dividend and earnings per share accruing to current investors.

Recently, a few key factors have played a critical role in driving strong U.S. stock market performance despite sub-par economic growth. First, in the post-financial crisis era, the Federal Reserve has reduced both the risk-free rate (through its quantitative easing programs and forward guidance announcements) and the equity risk premium (by its commitment to keep rates low for extended periods and by implicitly offering a “Fed Put”). The resultant reach for yield has pushed investors into riskier assets like stocks. Second, the rise of corporate market power has led to the emergence of superstar firms that are able to achieve abnormal profits. By construction, stock indices give more weight to the dominant winners of each era, and, in the era of the superstar firms, this creates a high degree of disconnect with the real economy.  

In the pandemic era, some troubling aspects have further amplified the disconnect between the stock market and the real economy. An unprecedented surge in liquidity from the Federal Reserve contributed to the rapid stock market recovery. Growing belief that the pandemic will alter the way we live, work and entertain, and the expected windfall from such a fundamental shift for Big Tech and a few other “winners” has caused the stock market to become top-heavy. The collective market value of the top ten stocks in the S&P 500 index recently stood at $8 trillion, and the top five stocks accounted for around 23 percent of the weight in the S&P 500. Complicating matters, new retail investors (attracted by the availability of convenient trading platforms that provide fractional share ownership and commission-free trades), driven by a “fear of missing out,” are jumping on the bandwagon. 

While there are rational explanations for the normal-level of disconnect between equity returns and economic performance, the current historically wide gap suggests the presence of significant distortions (unparalleled levels of monetary and fiscal stimulus) as well as heightened levels of uncertainty. A few not-so-far-fetched developments may trigger a sudden change in market sentiments: Overly-enthusiastic predictions regarding the future role of technology in our personal and work lives may turn out to be overblown, or the pace of economic recovery may not be in accord with stock market expectations, or a delay in vaccine development may occur. Entry of novice traders, an unstable political climate and upcoming U.S. elections pose additional risks.

All in all, it would be wise to be prepared for a sudden and sharp course correction in equity markets as the disconnect between the equity market and the real economy reaches historic proportions.

Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.