You have probably noticed that equities continued a strong rally in May. Wall Street has done well. On the 23rd March at its nadir the Dow Jones Industrial Average closed at 18,592. On Friday it stood at 27,111 a rise of 45.8%. Similarly the FTSE 100 index rallied from 4,994 to 6,484 over the same period, a gain of 29.8%. A word of caution though. The Dow Jones Industrial Average and the FTSE 100 are not the most representative stock market indices of their respective domestic economies, the S&P 500 and FTSE All Share are. These rose by 42.7% and 31.9% respectively, broadly similar to the gains of their narrower more internationally focussed sister indices.
Whatever you make of the figures it is clear markets seem to be pricing in a V shaped recovery to the economy and this is a puzzle given what is happening in the real word. Declines in global trade, a sharp rise in unemployment and existential threats to many businesses will damage the real economy in the short term at least if not permanently. And also why if dividends have been suspended and company earnings are being slashed are share prices rising? Is Wall Street (representing the markets) detached from Main Street (representing the real economy)? In a recent blog post Russ Mould, AJ Bell’s investment director addressed these questions. He makes the point that stock markets are forward looking and consequently they anticipate a future recovery in the economy and company profits. If however the cash generated in the future disappoints then share prices could unravel. Here Mould sounds a warning. He noted that corporate profits in the US as a percentage of GDP in the first quarter of 2020 fell to their lowest level since the first quarter of 2009 and that in nominal or cash terms corporate income from S&P 500 companies in Q4 2019 was no more than Q2 2014. A real increase in company profits is needed and pronto to justify current prices.
The rally in the equities since the end of March can also be explained by rapid and unprecedented fiscal and monetary stimulus from governments and central banks. Measures such as furloughing grants, business loans, tax deferrals and cutting interest rates are currently shielding businesses and the real economy but what happens when support is withdrawn? It can’t go on for ever.
You will not be surprised to learn that stock markets especially in USA are being supported by technology stocks such as Microsoft, Facebook, Amazon, Apple and Alphabet (the parent company of Google). Their earnings and balance sheets are seemingly invulnerable. Other defensive businesses such as food retailers and healthcare are also holding up well. The reality is sections of the economy are still doing fine and are supportive of share prices. In contrast mass failures in the tourism, hospitality, travel and retail industries are inevitable. Here in Eastbourne two large sea front hotels failed after the collapse of Shearings, a holiday coach company. Excluding major PLCs such as airlines and hotel groups many independent businesses such as small hotels, pubs, restaurants and shops are unlisted. They are either run by the self-employed or are private limited companies whose shares are not traded on a stock exchange. Mass failures here therefore will not directly affect stock market indices although they will impact the real economy. This illustrates an important principle that the economy and the stock markets although linked are not the same.
Despite the fact there are winners in the current crisis notably online businesses and that the rally in markets is partly justified it may well be a case of hope over reality. Unless Main Street delivers real economic recovery and earnings growth Wall Street may be in for a shock. Until then investors should treat the rally with some caution. Investors shouldn’t be fooled that the fair wind behind equities means the worst is over.
The content of this blog is intended as general investment information only. Nothing in this article should be construed as personal investment advice. You should seek individual advice based on your own financial circumstances before making investment decisions.