Explaining the Disconnect Between the Economy and Stock Market

This week, the S&P 500 flirted with overtaking its high watermark from February of this year, leaving many scratching their head as to how, and why, the stock market has rebounded this quickly. Since the bottom in March, the S&P 500 has risen approximately 50 percent, taking only 175 days for the index to complete a full peak-to-peak run. To help shed some light on the current state of the market, Barry Ritholtz wrote a piece on one of the reasons there is a disconnect between the economy and the broad stock market. One of these reasons being that the stock market is forward looking and reflecting all new information as it’s released; however, Ritholtz instead focuses on the concept of market capitalization and how this influences the performance of broad market indices. Although many of the more visible economic hardships resulting from the COVID-19 pandemic have materialized in industries like department stores and airlines, these sectors only make up 0.01 percent and 0.18 percent respectively of the S&P 500. On the other hand, internet content, software, consumer electronics, and internet retailers make up close to a quarter of the total U.S. stock market value, and these companies are on a tear and have been single handedly propelling U.S. stock indices higher. One can argue about whether or not the equity valuations for these technology companies are rational, but what can’t be argued is the effect that market capitalization has on the performance of stock indices. This highlights a challenge with individual stock selection, in that if you don’t have these tech leaders in your portfolio (or are underweight relative to the index), then you’re likely to be underperforming broad market capitalization weighted indices.