Why Main St and Wall St are very different places

  • By Enda
  • 16 Dec 2020

The last year has thrown up many things we find incomprehensible. From an investment point of view, the relatively strong performance of the stock market is certainly difficult to comprehend in light of the enormous difficulties faced by so many businesses in the real economy. What has been brought sharply into focus is that the stock market often fails to mirror the economy. In a study conducted by Dimson, Marsh and Staunton, they found that GDP growth and returns for the stock market are only slightly correlated over the long-term. Simply put, the stock market is a medium for investors to speculate on the present value of the future cashflows of publicly traded companies.

 

The disconnect between “Main Street’” (the economy) and Wall Street (the market) has arguably never seemed more pronounced than it is right now. If you had fallen asleep in January 2020 and just woken up to have a quick glance over the front pages of the Financial Times and at the level of some market indices, you would be forgiven for assuming that the economy was in a great place! At the time of writing, the S&P 500 is up circa 14% year to date, the Dow Jones Industrial Average is up 5% and the Nasdaq is up an incredible 37%. How can this be, these figures completely contradict what we see happening in so many parts of the real world so what is going on? First, the market is by nature forward-looking, while many widely reported economic indicators, such as GDP and Jobs data, are backwards-looking. COVID-19 has undoubtedly impacted the near-term prospects of many public companies but when we take a longer-term view of these same companies, the outlook can be significantly better.

 

Take the price-earnings multiple of the average stock in the S&P 500 as an example. When you buy a stock, you typically pay between 15 to 25 times that stocks earnings per share. Some stocks cost more, some less e.g. Apple at 33x versus Walgreens Boots at 7x. For long-term investors, who buy a stock based on that stocks earning potential over the next 10 to 20 years or more, shortterm issues are only one part of the investment picture. Because they are buying a stock for its earnings over the next 40 – 80 quarters, the fact that those earnings may be depressed for the next 6 to 7 quarters doesn’t affect the price as much as we may have assumed.

 

Second, the stock market represents only a small fraction of all global businesses. America alone has more than six million companies, the vast majority of them are not publicly quoted, in fact only about 3,000 of them are. The well-known S&P 500 for example, although consisting of the largest 500 US quoted companies, is still not fully representative of the broader economy. Third, the top 5 companies in the S&P 500 account for roughly 25% of its total market capitalisation (Apple, Amazon, Microsoft, Facebook, Google). All these companies have seen their businesses grow very strongly this year with their share prices up between 23% and 66% since the start of the year. The stellar performance of a small number of very large companies can significantly enhance the performance of the overall market.

 

The fourth and final factor we’d like to highlight has been the impact of monetary and fiscal policies pursued by central banks all over the world. The sheer volume of cash that central banks have  provided governments, by way of bond purchases, is unprecedented. According to a report by consultancy firm McKinsey, the percentage of the economic stimulus in the US was 12.1% of US GDP. This is more than double the 4.9% that was used during the great financial crisis of 2008/2009. Central banks across the globe have made it clear they are willing to do whatever it takes to rescue the economy and markets have reacted accordingly.

 

If you have been puzzled by the stock market this year, we hope you are now a little less so. Whilst none of us have any control over what is going to happen in the market it is important that we have a sense of what is happening so that we have the confidence to invest. Then we can spend our time concentrating on what we can control, how much we spend, how much we save, our longterm financial plan and the long-term investment strategy we commit to so that we can meet the needs of our plan.

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