With the Nasdaq, Dow and S&P 500 indices hitting all-time highs recently, you might be wondering if the stock market has become completely untethered from reality. After all, we’re still in the midst of a global pandemic that has resulted in a sharp rise in unemployment, millions of struggling businesses and individuals and a sharp contraction in Gross Domestic Product (GDP). Two adages might help explain this apparent disconnect:

  1. The stock market is not the economy. The family restaurants, hair salons and local gyms that are struggling or closing for good right now are not represented on the stock market. The major indices like the S&P 500 only represent the largest companies in the US, most of which have solid balance sheets and access to capital. Further compounding the issue, the S&P 500 index is being driven by a few large tech stocks, whose strong performance is amplified because the index is weighted based on the size of the company, so the larger the company gets, the more its performance counts in the index. As a result, tech companies like Apple, Amazon, Google and Microsoft are driving the performance of the overall index and their businesses have also been relatively resilient during the downturn.
  2. Don’t fight the Fed. When the Fed acts, markets respond. Just as the Fed stepped in aggressively during the Great Recession to provide liquidity to the financial system, this time around it responded even more quickly to provide liquidity and support. The Fed cut its target interest rate to 0% and has committed to keeping it there until the economy is closer to full employment. It also started purchasing Treasury bonds, corporate bonds and even bond exchange-traded funds (ETFs) to provide liquidity to the financial system. These efforts are providing support to companies and the investment markets.

A final consideration that might help explain the apparent disconnect between the stock market and the economy is that the market is forward-looking. A company’s stock price is the discounted present value of all future company profits to infinity. As such, the current year’s profits only account for 10% or less of the current stock price. So the strong performance of some companies can be explained by the fact that the market has already written off the current year’s downturn and has focused on the future recovery.

In summary, the stock market is not directly correlated to the performance of the economy. Its performance is reflective of the strong performance of a few large tech companies whose businesses have proven resilient. While another market correction will happen at some point, the stock market might continue its upward trajectory. As always, the best strategy is to maintain a globally diversified portfolio with a risk-reducing bond allocation and monitor regularly for rebalancing and tax-loss harvesting opportunities. These are the keys to long-term success in the investment markets.