Money Talks

The Stock Market Isn’t So Irrational After All

The stock market swings after Pfizer’s vaccine announcement prove that the market isn’t as wildly exuberant as many believe

Money Talks is a column that explores what happens when business, the economy, and culture collide.

If there’s been one cliché that has defined the stock market over the past eight months, it’s that “the market is disconnected from the real economy.” With stocks hitting all-time highs in the midst of the coronavirus pandemic — even though the U.S. economy was in recession and unemployment had risen sharply — it was easy to argue that stock prices had lost connection to economic reality. This was a crazy market, fueled by cheap money from the Fed and unrealistic hopes for the future.

Then came Monday. After news broke on Sunday that Pfizer’s new Covid-19 vaccine candidate was doing exceptionally well in clinical trials, stock futures soared overnight, and the S&P 500 opened the next morning up more than 4%. While at first glance, you might assume that was just further evidence that this is a market governed by emotion rather than economic fundamentals, under the surface something interesting was happening. On the whole, the market may have been up on Monday, but that fact disguised a more complicated reality, in which companies that could be expected to do well if the vaccine were effective — like movie theaters and airlines — saw their shares spike sharply, while “stay at home” stocks that might lose some of their relative advantage if the pandemic were to be controlled saw their shares fall. In other words, this was not a market in which investors were indiscriminately buying on the good news. It was a market in which investors were drawing distinctions between stocks, driving up the price of Delta’s shares while driving down the price of Clorox.

That might seem unsurprising, since that’s precisely what we expect investors to do. But that stark division in the way investors treated different companies in the wake of the vaccine news demonstrates, in the simplest sense, that the stock market is — and has been — far more connected to economic reality than the headlines suggest. Market commentary talked about Monday’s move as a simple example of “rotation,” with investors mindlessly moving money from growth stocks to value stocks. But the distinctions investors drew on Monday weren’t, ultimately, about distinguishing between value and growth. (Clorox is no one’s idea of a growth stock.) They were about distinguishing between stocks that will benefit from things getting back to normal versus stocks that will be hurt by it.

If that’s not shocking, it’s because this is what investors have largely been doing since April, all the headlines about what a crazy market this is notwithstanding. There’s always been a problem with the “the market is disconnected from the economy” thesis, namely that the performance of the market over the past six months has been largely driven by a relatively small number of stocks, precisely the stocks that one would expect to do well (and that have done well) during a pandemic. Five stocks — Microsoft, Apple, Amazon, Alphabet (parent of Google), and Facebook — have accounted for roughly 20% or more of the S&P 500’s entire market cap over this period, and all of them have seen revenues and earnings rise since the pandemic began. Add in companies that have thrived as a result of people staying home, like Zoom and Peloton, and the companies that have benefited from pandemic concerns, like Clorox and Walmart, and you account for most of the rise in stock prices this year.

If the market were, in fact, disconnected from reality, it would have been bidding up prices across the board. But that hasn’t really happened.

In other words, while it seems like there’s been a disjunction between stock prices as a whole and the economy as a whole, that generalization obscures the fact that the companies whose stocks have been doing well are, by and large, also doing well economically. If the market were, in fact, disconnected from reality, it would have been bidding up prices across the board. But that hasn’t really happened. And while you might argue it’s odd that stock prices of companies that haven’t benefited from the pandemic have held up as well as they have, the odd reality of this recession is that average personal income hasn’t fallen, thanks to the stimulus package and improved unemployment benefits Congress passed in the spring. And some consumer sectors — like appliances — have actually seen sales boom.

The bigger point to be taken away from this is that even though we’ve become accustomed to talking about the “stock market” as if it were a living being, making decisions about which way it is going to go, this is a mirage. Instead of one thing, it’s the aggregate of innumerable different decisions investors are making. And when it’s functioning as it should, those decisions don’t all point in the same direction, or treat all companies the same.

Markets thrive when investors are diverse in their opinions, and when they draw distinctions between companies, rather than buying and selling en masse. There are, increasingly, factors that tend to work against this: the rise of momentum-trading algorithms that look to amplify existing trends in the market rather than counter them, and the rise of shadow-indexing, where money managers build portfolios that closely mimic market indices, rather than try to outperform them. But even with these factors in place, the market is still relatively diverse, and therefore difficult for even the savviest investor to outperform. Indeed, a recent study that looked at 50 different indicators that have been linked to behavioral biases found that most of the time, there’s little or no correlation between any of these biases and the market’s performance. In other words, even though investors may be individually biased, collectively those biases typically cancel each other out.

The moment when stock prices really lost touch with reality wasn’t when they rebounded from the Covid-driven sell-off, but rather when they sold off in the first place.

There are times, though, when this breaks down, when the market is collectively seized by emotion, and loses touch with reality. And the irony is that while that’s what lots of people have been saying the market has been doing for the past seven months, the moment when stock prices really lost touch with reality wasn’t when they rebounded from the Covid-driven sell-off, but rather when they sold off in the first place. Indeed, when you go back and look at the stock market sell-off that started on February 24 and lasted almost exactly a month, what’s fascinating is that investors failed to make the kinds of distinctions between stocks that they made in the months that followed. Instead of selling off stocks that were vulnerable to the pandemic while bidding up stocks that might benefit from it, investors sold just about everything, with even companies like Amazon and Netflix seeing their shares drop by more than 20%. That, in fact, was the moment when stocks were most firmly disconnected from the economy. Monday was a sign that they’re back in touch.

I’m the author of The Wisdom of Crowds. I’ve been a business columnist for Slate and The New Yorker and written for a wide range of other publications.

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