Why is there a growing disconnect between the stock market and the real economy and what are the options for the prudent investor?

Touzibozhu
Stock Markets

As the world continues to struggle with the Covid-19 pandemic, the rapid spread of the infection, the mounting death toll and economic destruction have brought many countries to the brink. Yet, financial markets seem to have disconnected from the real economy, having staged a strong rebound from the massive losses in March to enter a fresh bull market.

There are no shortage of expert opinions on why there is a growing divergence between the financial markets and the real world. Some aspects of this curious phenomenon can be explained by the accommodative monetary policies of the Central Banks and the generous fiscal stimulus packages put up by Governments caught flat-footed by the Covid-19 virus outbreak.

Central Bank Monetary Policies

As the crisis unfolded, Central Banks around the world responded in a timely manner to support the financial markets and to mitigate the damage to the real economy. Some of the accommodative monetary policies adopted by the Central Banks include the following:

  • Instituting aggressive policy rate cuts to reduce the cost of borrowing and to stimulate economic activity.
  • Providing ample liquidity support to the distressed financial markets.
  • Stepping in to purchase financial assets such as government bonds and corporate debt to keep the financial markets functioning.

Government Fiscal Policies

Following the actions taken by the Central Banks, Governments around the world have also implemented massive fiscal stimulus packages to stem job losses and to arrest the rapid decline of the real economy. Examples of these packages include payroll/job support schemes, soft loans to SMEs, debt moratorium and direct cash handouts. Many Governments expect to incur substantial budget deficits this year because of these fiscal policies.

Financial Markets are forward looking

Financial markets have the uncanny ability to look beyond the present crisis, to anticipate the eventual economic recovery down the road. At this point the Global Stock Markets, rightly or wrongly, are pricing in a V-shaped recovery in the real economy.

It's a liquidity driven rally

With so much liquidity being pumped into the financial markets through the concerted efforts of the Global Central Banks, stock markets inevitably reversed their downward trend and quickly began to climb upwards. The appropriate real world analogy is that of a balloon continuing to expand as long as air is being blown into it. As the markets began to rise, asset managers, whose performance are benchmarked against the stock indices, were compelled to participate in the rally for fear of missing out (FOMO). The virtuous cycle fed upon itself and in a relatively short time stocks managed to climb out of bear territory and gave birth to a new bull market.

Money is cheap these days

As part of the Central Bank monetary policies, interest rate or the price of money has been driven to nearly zero or even negative in certain parts of the world, and we are not referring to some obscure banana republic. Low interest rates play a significant role in inflating asset prices as it increases the present value of future cash flows. In other words, the ultra low interest rates helped to inflate the value of financial assets which added more fuel to the financial markets. The ultra low financing costs also enabled speculators to further increase their leveraged bets on the rise of the stock markets.

Hope Springs Eternal - The Global Race to develop Covid-19 Vaccines

There is an intense global race to develop the first effective Covid-19 vaccine. The WHO has reported that there are more than 100 vaccines in preclinical development and 10 promising candidates undergoing clinical trials. With the aid of cutting edge technology and techniques the development time for these new generation of vaccines has been dramatically shortened from the historical average of 10 years. While researchers generally regard 18 months to be an aggressive goal for the successful development of a vaccine, there are companies which are preparing to have hundreds of millions of doses available for distribution by year-end.

Naturally all these activities have provided more than a glimmer of hope for investors looking to capitalize on the global economic recovery from the pandemic and has played no small role in generating the seemingly irrational exuberance that we are witnessing in the global financial markets.

Now that we know the reasons for the growing divergence between the stock market and the real economy, where do we go from here?

It is now increasingly clear that the stock market has taken a life of its own and has diverged from current economic realities. The reasons for optimism are justifiable in that the unprecedented Central Bank monetary policies and Government fiscal stimulus packages have so far proven to be effective in mitigating the short-term economic damage from the Covid-19 pandemic.

Markets are also optimistic that the scientific and medical community will eventually develop a viable drug treatment or an effective vaccine for this disease, allowing the resumption of work, business and commercial activities which will lead to the much-needed restoration of Global economic growth.

There is no doubt that market participants are pricing in a V-shaped recovery and have been emboldened by the valiant efforts of the Central Banks and Governments around the world to backstop the Global economy from further deterioration. But what if the much anticipated economic recovery is not V-shaped but turns out to be U-shaped or even L-shaped? Investors have been proven to be overly optimistic on many occasions in the past, and in such times the stock markets inevitably experienced a trend reversal and corrected downwards.

So what can we do at this point in time? There are probably two reasonable choices for the prudent investor:

  1. The conservative investor would probably hold on to cash and live to fight another day. One of the most famous investors of all time, Warren Buffett has reportedly chosen to trim his stock holdings and raise record amount of cash in the recent market downturn. and The downside to this approach is that one would have to watch in envy as other investors reap their profits in the rising markets.
  2. Alternatively, the more aggressive investors would choose to hold on to the ride and enjoy the rewards of a liquidity driven market rally. One would be well advised to employ the tools of technical analysis to watch closely for trend reversals and set trailing stop loss orders to protect the hard-earned gains.

In either case, investors would do well to remember the important principle of "Caveat Emptor". Ignore it at your own peril.