Investing for Dummies
The two financial terms we hear about the most shouldn’t be confused.
In the world of financial news, headlines can be confusing. Just when one proclaims that stock markets are hitting record highs, another may just as easily say the economy is in deep trouble. But how can this be? How can stock market numbers look so rosy next to a gloomy outlook for the economy?
The simple explanation is that the two are very different. Yet they each affect one another to such a significant degree that the relationship between them remains critical to our financial system – even when they move in different directions.
Stock markets, such as the Dow Jones Industrial Average, the Standard & Poor’s (S&P) 500 Index and the S&P/TSX Composite Index (Toronto Stock Exchange) understandably get a lot of attention. After all, stock markets are where the action is. Massive amounts of money are traded each day, while numbers bounce between highs and lows in reaction to the latest economic news and activity. Meanwhile, speculation about what will pay off and what won’t continuously drives the markets forward.
At their core, stock markets showcase the financial strength of publicly listed companies from various sectors of the economy, such as energy, natural resources, finance and technology. They thrive on a combination of speculation, factual financial information and risk tolerance, which investors measure to project a company’s potential for future profit and growth. The economy, in contrast, is considerably larger and more complex and affects people’s lives more directly than the markets.
Booms and busts
When the COVID-19 pandemic spread around the world in early 2020, global stock markets went into a tailspin. Many businesses were closing, most air travel was grounded indefinitely and unemployment numbers were rising fast. As a result, the Canadian economy suffered its worst quarter ever, contracting 38.7 per cent on an annualized basis in the second quarter of the year. But even as the disease raged on, markets began to recover their losses through the second quarter despite the economic impacts of the widespread effort to contain the virus. The market momentum continued in defiance of the dire economic outlook.
“The stock market is meant to be forward-looking. In general, what you see right now in the economy is what’s going on right now, such as production, employment and so forth. Even in normal times, stock prices and economic output would not move in tandem.”
- Itay Goldstein, Professor of Finance, Wharton School of Business at the University of Pennsylvania
To use a vivid example, the five companies with the largest market capitalization on the S&P 500 Index (at December 2020) are the technology giants Apple, Microsoft, Facebook, Amazon and Alphabet (Google), which together account for about one-fifth of the index’s market value.. This concentration means that the overall index does not paint a very broad picture of how the economy is performing overall. Consider that Apple’s share value alone exceeded US$2 trillion in August 2020. In other words, it demonstrates that a single company can hold more stock value than all the other companies listed on a single stock exchange combined. This reflects the great confidence investors have in the current and future state of the company. In contrast, retail operations and energy companies had a tougher time keeping their stock values trending upward in 2020.
It’s clear that even when most of the usually robust economic engines are running on fumes, others can continue to outperform due to the demand for certain products and services. Some of the best examples are companies in the digital technology and health sciences sectors, which have prospered during the pandemic, as more people and businesses became increasingly reliant on them.
The story also changes when you look beyond the major players in each sector. Economic downturns can have a more negative effect on small and medium-sized businesses, which in Canada make up 70 per cent of private sector employment. These companies generally have less ability to withstand the financial pressure brought on by a major crisis and are more at risk of having to cut jobs, shutting down temporarily because of pandemic restrictions and possibly closing down for good, which further undercuts economic activity.