A Potemkin Village market?

While the adage that the stock market isn't the economy and vice versa is true. one of the puzzles facing investors is why the US equity market testing its all-time highs even as the economy suffered its worst setback since the Great Depression. This market seems like a Potemkin Village, which shows an external façade of calm while hiding the real trouble behind the scenes.

The Fed isn't entirely responsible for the market's strength. The Fed has taken steps to stabilize markets so they can function in an orderly way. A Fed Put can put a floor on prices, but it cannot make asset prices skyrocket the way they did.

A more reasonable explanation is the unprecedented level of fiscal support to support growth. This recession is completely unlike past slowdowns. The government's safety net has allowed consumers to maintain their spending to prevent a complete collapse in demand.

In that case, why hasn't the stock market skidded as it became clear that Congress could not agree on a second stimulus package, and that Trump's Executive Order and Memoranda designed to do and end run around Congress appears to be ineffectual (see a detailed analysis in Earnings Monitor: Slower growth ahead). The Washington Post reported that the Street generally agrees with my analysis.

“If this is all we get for fiscal policy for the rest of the year it would represent a significant downside risk to our growth outlook,” JPMorgan Chase chief U.S. economist Michael Feroli wrote in a Monday note. “These executive orders likely will provide stimulus of less than $100 billion, while we have been expecting Congress to add at least $1.0-1.5 trillion of spending once an agreement is reached.”

The team at Oxford Economics comes to a similar conclusion, finding “the relief is inadequate, legally questionable and falls dramatically short of the booster shot the economy desperately needs,” per a note from senior U.S. economist Lydia Boussour. “In the absence of a more comprehensive stimulus package, economic activity will be constrained just as the recovery plateaus.”

Barry Ritholz offered a different sort of explanation, based on a radical difference between the construction of the market indices and the economy, in a Bloomberg opinion piece. Big Tech comprise a gargantuan weight in most major US indices.

The so-called FAANGs (along with Microsoft) derive about half -- and in some cases even more -- of their revenue from abroad. Beyond that, the pandemic lockdown in the U.S. has benefitted the giant tech companies’ sales and profits. No wonder the Nasdaq Composite 100 Index, which is dominated by big tech companies, is up about 26% this year.

Simply put, the rest of the market really doesn't matter no matter how badly the underlying sectors and industries perform.

Take the 10 biggest technology companies in the S+P 500 and weight them equally, and they would be up more than 37% for the year. Do the same for the next 490 names in the index, and they are down about 7.7%. That shows just how much a few giants matter to the index.

On some level, it’s completely understandable why many people believe that markets are no longer tethered to reality because the performance doesn’t correspond to their personal experience, which is one of job loss, economic hardship and personal despair. But what’s important to understand is that indexes based on market-cap weighting can be -- as they are now -- driven by the gains of just a handful of companies.

This week, we explore the outlooks and performance of two groups, Big Tech, and the rest of the market.

The full post can be found here.