How the economy, the equity market, and the fortunes of workers are drifting apart.
US unemployment remains near a post–World War II high while the stock market is up more than 40% from its March lows. The decoupling of the broader economy with the equity market has left many investors scratching their heads. While long-term equity returns have roots in a strong economy, short-term stock market fluctuations have never been a good gauge for the economy—and vice versa. To understand why, it’s easiest to look at the link—or lack thereof—between the two. Structural changes in the nature of firms driving broad, capitalization-weighted indexes higher may also impact job creation mechanisms—which is possibly the most critical measure of a vibrant economy.
The link between economy and market
Since the Bretton Woods conference of July 1944, GDP has been the most common measure of a country’s economy. In basic terms, GDP is the monetary value of all final goods and services produced in a country, with each good and service weighted according to its share in the economy. Typically, the first year—also known as the base year—is set to 100, and all subsequent years reflect a change from the base. To calculate GDP, the government collects data throughout each quarter and then releases an initial estimate approximately 30 days after quarter-end. The initial GDP estimate may be revised over time as more information becomes available.
GDP growth translates to equity shareholders through a multistep process. First, the growth in GDP becomes growth in corporate profits. Not all growth in GDP translates to corporate profits—there is dilution. For example, a portion of GDP growth comes from investing in new shares in the form of initial and seasoned equity offerings that don’t translate into corporate profits. William J. Bernstein and Robert D. Arnott estimated dilution to be about 2% annually. With this in mind, corporate profit growth can then be converted into earnings per share growth. The final step is valuing equity shares based on a price/earnings (P/E) metric.
When considering how economic growth relates to potential earnings and share prices, we can easily see where the two may disconnect. First, equity markets are ruthlessly forward looking. Changes in equity prices are based on investor perceptions of future growth opportunities in the quarters and years ahead and appropriately discounted back to the present. In other words, equity prices today represent the collective market’s expectation of the future. GDP, like many economic statistics, is backward looking. It’s measured with error and lag. From a practical standpoint, the equity market races ahead of what we understand to be the current economic state.
Further, GDP measures only the market value of goods and services produced in the US. Large multinational firms may generate significant earnings outside the US in a manner that doesn’t contribute to GDP. For example, Apple manufactures phones in China that are sold in Europe. This activity is outside the US economy, but it generates earnings for a US company.
Finally, P/E multiple variation can have a material impact. Even if GDP and earnings remain unchanged, P/E multiple expansion or contraction can drive substantial equity price evolutions. The chart below shows the variability of the P/E ratio for the S&P 500® over the last decade.
Trailing 12-month P/E ratio for the S&P 500®
Source: Bloomberg, 6/17/2020. For illustrative purposes only. Not a recommendation to buy or sell any security. It is not possible to invest directly in an index.
When the leak becomes a flood
Let’s take our understanding of the link between GDP and the equity market and refocus it on the current environment. More specifically, six large firms that have been the primary driver of exceptional US equity capitalization growth—relative to all other equities—since 2015. These six stocks commonly go by the acronym FAAANM, and they include:
Source: Bloomberg, 6/30/2020. References to specific securities and their issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, a recommendation to purchase or sell such securities. Any specific securities mentioned are not representative of all securities purchased, sold, or recommended for advisory clients. It should not be assumed that any of the securities or recommendations made in the future will be profitable or will equal the performance of the listed securities.
The FAAANM stocks represent five of the top six stocks—by market cap—in the S&P 500®. As of June 30, JNJ is the first non-tech company on the list at number six. Netflix is number 18 on the list. In total, FAAANM shares have a current weight of 21.7% in the S&P 500®. All six trade at P/E ratios well above that of the index.
The importance of FAAANM stocks in the S&P 500® has grown dramatically over time. Since the beginning of 2015, a cap-weighted index of FAAANM stocks produced a cumulative total return of 236%, while the S&P 500® without the FAAANM stocks—494 companies—produced a cumulative total return of just 39%. In aggregate market value terms, of the $6.3 trillion in total S&P 500® market capitalization growth since 2015, FAAANM stocks account for just under 60%, while the other 494 firms explain the balance.
As we look forward, we may infer that the FAAANM stocks’ success bodes well for the future. At the very least, these successful US companies will generate good-paying jobs for workers. Here again, we see that the FAAANM stocks are different. They’re employee light. As the chart below indicates, the number of employees per $10 million in market cap has been steadily declining in recent years, notably accelerated by the increasing growth of FAAANM shares.
Number of employees per $10 million in capitalization
Source: Bloomberg, 6/17/2020
In testimony before Congress in 1953, Charles Wilson, the CEO of GM, confidently stated, “What was good for our country was good for General Motors, and vice versa.” At the time, GM had manufacturing facilities across the US that employed hundreds of thousands of people. Wilson couldn’t conceive of a scenario where GM and the country’s fortunes weren’t aligned. While the six FAAANM companies are important to the US economy, one couldn’t make that statement today with the same conviction for any of them. They simply don’t produce jobs like other large-cap market leaders have in the past. Moreover, as FAAANM companies continue to generate a material percentage of their earnings outside the US, their fortunes don’t depend entirely on the fortunes of the US economy.
The bottom line
Although strong economic growth provides the base for a vibrant equity market, the relationship between the performance of the stock market and the economy has always been tenuous. In short, Main Street is not Wall Street. That relationship has become even more strained in recent years due to the rise in prominence of the modern technology companies that generate earnings around the globe in an employee-light manner.