Why is the stock market rallying when the economy is heading into recession?

To the average person on the street, it seems illogical when we hear about economic recession and high unemployment levels but the share market is going up. At Fairmont Equities, we have been bullish on the share market since the end of March, buying up stocks that will benefit from an economic rebound. With the Australian market sailing past our short-term target of 6000, it has left many people scratching their heads and wondering why shares have rallied so strongly. Here we provide a simple explanation as to why the stock market rallies when the economy looks fragile.

Stock markets are forward looking

The share market found a low in March, which was the peak of the COVID-19 panic. Investors were looking forward to a very bleak future and were trying to price this in on very limited information. Once it became evident that the situation could improve from a very low base, the market started to recover. Jobs losses have occurred, but this was due to the compulsory shut down of some businesses. As restrictions looked to be lifted sooner than what was previously priced in, with the assumption that people will be rehired quicker than expected and the economy bouncing back earlier than expected, the share market started to rally.  The share market is forward looking, so investors are predicting what is likely to happen into the future. Economic figures look bleak now, but the market is looking beyond this. Economists are looking at past data and lagging indicators. A recession is defined as a fall in GDP in two successive quarters (so they look at the economic data which has already occurred). Investors believe there will be a V-shaped recovery in the economy from this point on. This means that it will revert close to normal levels at a rapid rate.

New infection rates decreasing

Investors are feeling confident about the future as new infection rates in Australia have been low or on same days, zero. Even in the US and Europe they are past the peak and are slowing down. This means that we are getting closer and closer to the economy reopening.

Government Stimulus

We have previously discussed on this blog the methods that the government may undertake to boost the economy. This may include lowering interest rates, or quantitative easing. Investors see this support from Government and Central Banks as positive to share markets. Decreased interest rates and stimulus packages have given households more income which in turn leads to higher investor confidence.

The stock market doesn’t reflect what is happening in the private sector

The stock market only consists of companies which are publicly listed, so private companies are not reflected in the stock market indices. Hence small private firms may be more vulnerable to the shutdown and this is not conveyed in the share market performances. Small firms tend to have less cash reserves than bigger firms so they will more likely feel the brunt of the economic downturn a lot more.

Stock prices do not always reflect intrinsic value

Stock prices are affected by supply and demand, they do not always reflect the actual earning capacity of a company but rather, what an investor may be willing to buy and sell the stock for. A company may not be earning any money but investors may be willing to pay a high price for the stock for the potential of what the company can produce in the future.

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Lauren Hua is a private client adviser at Fairmont Equities.

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