Historically, changes in global equity prices have been closely related to changes in the global economy. However, this has not been the case for most of 2020.
The current "disconnect" has led many investors to ponder whether the magnitude of the equity market rally since March is justified.
Is it possible for us to learn from the outcomes of similar episodes?
This piece aims to quantify the stock/economy disconnect and analyses the outcomes of the large disconnects of the past.
The chart below shows the one-year global economic data change and the one-year return of global equities. We can see that the timing and amplitude of these series tend to coincide very closely.
Yet in 2020, the stock market was priced ahead of the economy before the pandemic correction began in late February.
And what happened since then will surely go into the financial history books - a swift plunge followed by a complete recovery in stock prices, well before the recovery in the global economy.
Let's quantify the "disconnect" as the difference between how much stock prices changed in the prior year and the change in stock prices which would have been expected based on the change in the economic data.
The disconnect is essentially the distance between the two lines on the chart above, translated into stock price terms.
We can observe that more than two-thirds of the time the disconnect has been small, with the change in stock prices being within 10% of what was implied by the change in economic data.
In the current episode the disconnect has been large, with stock prices more than 20% ahead of the economic data continuously from April into September.
Some degree of stock/economy disconnects should be expected and not alarming; after all, the economic data tells us about the past, while the stock market is forward-looking.
If the global equity return has been much higher than what can be explained by the prior year change in the global economy, perhaps stock market investors are anticipating there will be a strong improvement in the economy in the year ahead.
Also, there are other influences on stock prices besides economic growth such as interest rate changes.
But is it reasonable for us to expect this magnitude of disconnect? In the chart below, we look at episodes of great disconnects beyond +/- 20%, along with the cumulative global equity return (net of cash).
In the yellow/blue shaded periods, the prior year stock return was 20% or more above/below what would have been expected given the change in the economic data.
The surprising result of our analysis is that when the disconnects have been large, what happened next was often the opposite of what stock investors appeared to expect.
Stock prices often fell after the stock market was well ahead of the economy (in red) and rose after the stock market was well behind the economy (in green).
On average, the subsequent one-year return for global equities was more than 10% below the cash return after the disconnects of over +20% and more than 10% above cash when the disconnects were below -20%.
The positive disconnect of 2020 is unusual in that it began during a global recession. Most of the past instances where stock market prices raced ahead of the economy occurred in expansion periods.
The explanations for this year's disconnect are well known: it was reasonable to expect some economic recovery as virus-related lockdowns were lifted.
Moreover, there has been enormous fiscal and monetary policy intervention supporting asset prices.
However, even if the global economy has begun to rebound, the amount still to go to fully recover is enormous - larger than the maximum gap reached during the Global Financial Crisis.
Unsurprisingly, the pace of recovery has slowed down recently as the fiscal and monetary policy support has fallen back from the aggressive initial levels.
In addition to the still large year-over-year economic decline, other important information which is typically relevant to equity outcomes is also quite negative: valuation, volatility, the trend in earnings.
In conclusion, our analysis suggests that large disconnects between stock prices and economic reality usually lead to regret among equity investors.
While it is tempting to claim that this time is different due to the extraordinary policy interventions, we think it might be worthwhile to protect the gains already obtained in equity portfolios.
Ken Frier is principal at SECOR Asset Management