Supports: Econ (Chapter 8 – Firms, the Stock Market, and Corporate Governance; Micro (Chapter 8): Macro (Chapter 6); Essentials: Chapter 6.
Apply the Concept: If the Economy Is Down, Why Is the Stock Market Up?
Here’s the Key Point: In determining a firm’s stock price, the firm’s current profitability is less important than its expected future profitability.
The price of a share of stock reflects the profitability of the firm that issued it. During economic recessions, firms experience declining sales and profits and the prices of their stocks fall. We saw such a decline at the beginning of the downturn caused by the Covid-19 pandemic in 2020. As the following figure shows, the S&P 500 stock market price index reached a high the week ending on February 14. By the week ending on March 20, this index had declined by 29 percent.
On the figure, the shaded area shows the weeks during this period when the economy was in a recession. We are dating the beginning of the recession using the Weekly Economic Index published by the New York Federal Reserve and compiled by James Stock of Harvard, Daniel Lewis of the New York Federal Reserve, and Karel Mertens of the Dallas Federal Reserve. The index is comprised of 10 economic variables including sales in retail stores, claims by laid off workers for government unemployment insurance payments, steel production, and railroad freight traffic.
Notice two things about the figure:
- Stock prices began to fall in mid-February 2020, about a month before the recession began in mid-March. This result is not surprising because the stock market is often a leading indicator, that is, stock prices tend to decline before production and employment fall. The incomes of professional stock traders and managers of mutual funds and exchange-traded funds (ETFs) depend in part on their ability to sell stocks before their prices decline and buy them before their prices increase. So these finance professionals have a strong incentive to attempt to anticipate changes in the economy before they occur.
- Stock prices began to rise in mid-March while the economy was still in recession. In fact, the S&P 500 stock index increased more than 20 percent between mid-March and early May even though, as measured by the WEI, the economic recession was becoming worse as production and employment were rapidly declining. This result surprised many people who had trouble understanding how, as the headline of an article in the New York Times put it: “The Bad News Won’t Stop, but Markets Keep Rising.”
Both these points reflect the same key fact about the stock market: Although a firm’s stock price depends on the firm’s profitability, the firm’s current profitability is less important than its expected future profitability. You wouldn’t pay much for the stock of a firm that was making a profit today but that you expect will be driven out of business in the future by another firm about to introduce a superior competing product. Even though the profitability of most firms in the United States had yet to decline in mid-February, many investors were beginning to fear that Covid-19 would have a major effect on the U.S. economy, so stock prices began to decline.
Why then did stock prices turnaround and begin to rise only a month later, and why did they rise and fall significantly on many days? Those swings in stock prices reflected a key result of investors interacting in financial markets: Buying and selling of financial assets like stocks results in the prices of those assets fully reflecting all the available information relevant to the value of the assets. In the case of the stock market, buying and selling stock results in stock prices reflecting all available information on the future profitability of the firms issuing the stock. New information that is favorable to the future profitability of a firm—for instance, Apple announces that iPhone sales have been higher than investors expected—will lead investors to increase demand for the firm’s stock, raising its price. The opposite happens when new information becomes available that is unfavorable to the future profitability of a firm.
Because new information becomes available continually, we would expect stock prices to change day-to-day, hour-to-hour, and minute-to-minute. Stock prices for the market as a whole, as reflected in stock price indexes like the S&P 500, will rise and fall as new information becomes available on the future strength of the economy. During the Covid-19 pandemic, investors were particularly concerned with the following four issues:
- The development of new medical treatments for the disease, particularly vaccines.
- The effectiveness of government programs, such as loans to businesses, that were intended to help the economy recover from the effects of the lockdowns used to reduce the spread of the virus.
- The ability of the economy to adjust to the possibility that the virus might persist in some form for years.
- The willingness of consumers to resume buying goods and services, such as restaurant meals and movie tickets, that seemed particularly affected by the virus.
Optimistic news about these factors, such as successful early trials of a vaccine for use against Covid-19, caused sharp increases in stock prices and pessimistic news caused prices to fall. For example, here are the percentage changes in the S&P 500 stock price index for consecutive trading days in mid-March (the stock market is closed on Saturdays and Sundays):
Stock prices are rarely this volatile. Wall Street investment professionals spend a great deal of effort gathering all possible information about the future profitability of firms, but in this period they had difficulty interpreting the importance of new information. No investor had experienced a pandemic as severe as Covid-19, so it was particularly challenging for them to determine the implications of new information for the likely future strength of the economy and, therefore, to the profitability of firms.
The large fluctuations in stock prices were another indication of how unusual an event the Covid-19 pandemic was and the difficulty that investors had in understanding its likely long-run effects on the U.S. economy.
Sources: Matt Phillips, “The Bad News Won’t Stop, but Markets Keep Rising,” New York Times, April 29, 2020; and Federal Reserve Bank of St. Louis.
In May 2020, an article in New York Magazine noted that, “The stock market zoomed on Monday in response to very preliminary positive news about a vaccine” being tested by the pharmaceutical firm Moderna. Positive news about one of its products might be expected to increase Moderna’s future profits and the price of its stock, but why would prices of many other stocks increase on this news?
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