According to the U.S. Commerce Department, the country’s gross domestic product decreased by 4.8% during the first quarter of 2020 alone, a figure that hasn’t been seen since the Great Recession in 2008. This number could easily worsen in the second quarter as the full effects of Covid-19 lockdowns will finally be displayed in labor statistics and earnings results.
On top of Covid-19, the U.S. has also seen turmoil in recent weeks as protests over the police killing of George Floyd kicked off widespread calls to stop institutional and racialized police brutality. Clashes between police and protestors have led to curfews being imposed and National Guard troops being deployed in several major cities.
Despite the potent combination of a pandemic and civil unrest, however, the stock market continues its upwards journey from March lows. As represented in the below chart of the SPDR S&P 500 (SPY, Financial) exchange-traded fune, the benchmark for the U.S. stock market peaked on Feb. 19 before falling 33% through March 23, then rising 37% to close at 3,055.73 on June 1.
It seems to defy all reason – why would the stock market continue to rise as economic conditions continue to worsen? For an answer to this question, we can look back at a similar set of circumstances that occurred in 1968.
The 1968 disconnect
Often called “the year that shattered America,” 1968 was the point where mounting discontent over the Cold War, the Vietnam War and multiple civil rights issues boiled over. Protests were held all over the country, divisive issues ruled the presidential race and Martin Luther King Jr. was assassinated. The H3N2 influenza pandemic killed over 100,000 people in the U.S. and millions more around the world.
In the same year, the S&P 500 fell 9% from January to March before rebounding 24% to close approximately 7.6% higher for the year.
The apparent disconnect between underlying economic conditions and the stock market was not new even in 1968. In the end, stock prices depend on what the collective body of investors is willing and able to pay for them. This principle extends to the market as a whole – the stock market is worth what people think it is worth. It has never been entirely dependent on earnings.
Greed versus fear
One dynamic behind why the prices of stocks often become disconnected from economic reality is the amount of greed versus fear in the markets. When investors are “greedy,” i.e., when they think the economy is going to improve in the near future, they tend to do more buying than selling, willing to pay higher prices for the potential of growth. On the other hand, when investors are “fearful,” i.e., they expect the economy to worsen, they tend to do more selling at lower prices.
As Warren Buffett (Trades, Portfolio) famously said, “Be fearful when others are greedy and greedy when others are fearful.” This basic tenet of value investing highlights how the stock market moves in the opposite direction of underlying market conditions more often than it moves in the same direction.
Thus, a potential reason behind the 1968 stock market rally is that investors saw the turmoil as an opportunity to buy stocks while business conditions were unfavorable, expecting a higher chance of improvement in the future. War, disease and civil unrest are things that most people recognize as temporary rather than permanent, adding to hopes of recovery on the horizon.
The Civil Rights Act of 1968, which was an important step towards racial equality, likely played an important role in raising hopes, as did the election of a new president and further optimism that the new administration would bring peace to the country.
The 2020 stock market
So far, 2020 seems to be heading in a similar direction to 1968 with its combination of a pandemic, civil unrest and a stock market that is flourishing even as underlying business conditions worsen.
Athough there are several similarities between the two years, there are also many differences, and not just on the surface level.
One important thing to note is that while U.S. GDP declined 4.8% in the first quarter of 2020 and is expected to continue falling in the second quarter, it increased by 4.8% in 1968. In order for 2020 to see an overall increase in GDP, the U.S. would have to do more than simply make up losses in the second half of the year.
Another important difference between then and now is that, compared to running a trade surplus in 1968 (top chart), the U.S. is running a trade deficit in 2020 (bottom chart). One effect of this is that the U.S. economy has become increasingly dependent on foreign economic conditions, making the earnings of companies and citizens alike more difficult to estimate without taking the global economy and foreign relations into consideration.
Additionally, the U.S. economy is more overvalued in 2020 than it was in 1968 according to the Buffett Indicator, which measures market valuation by comparing total market cap to GDP. One potent contributor to this overvaluation is the rise of index trading, which makes it easier for investors to make broad bets without doing research on the underlying companies. As of June 2, the indicator shows that the stock market is significantly overvalued, with total market cap measuring 145% of GDP.
Conclusion
The combination of a pandemic, civil unrest and a rallying stock market are things that 2020 has in common with 1968. However, disconnection between economic reality and the stock market is certainly not unique to these two years. There are also many differences in the 2020 economy compared to 1968, including GDP moving in opposite directions, changes in trading conditions and the rise of index trading. As for cross-border tensions and wars in foreign countries, there's still half a year to go before we see whether things will escalate or (hopefully) de-escalate.
As Peter Lynch once said, “You can flip a coin over where the market is headed over the next year.” Investors have no way of knowing ahead of time whether investor optimism will lead stock prices higher in the short term, or whether the combination of overvaluation and a sharp drop in GDP will send markets into a tailspin.
Disclosure: None.
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