Rise in stocks not based on wishful thinking

Market's performance a reflection of continued undervalued equity prices, says industry insider

Rise in stocks not based on wishful thinking

The rise in stocks is not based on fantasy but on continued undervalued equity prices for most industries, according to a chief economist.

The dichotomy between the market and economy has been a constant narrative throughout the pandemic. The lockdown hit hard, with real GDP down 5% at an annual rate in the first quarter and 31.4% in the second, the latter the steepest drop in real GDP since the Great Depression.

The third quarter offers encouragement and, according to reports, likely grew somewhere between 30-35% at an annual rate. The rebound has been put down to a shift in activity towards businesses that stayed open because they were “essential” and those that actually re-opened. Despite this, the lockdown damage means it’ll take until late 2021 to fully get back to where it was pre-COVID-19.

Brian Wesbury, of First Trust Advisors, stressed that stock market investors are not buying shares of GDP, they're buying shares of specific companies that provide specific goods and services.

He said: “Many of these have had and will have robust profits or healthy rebounds in profits to entice investors.

“Economy-wide corporate profits peaked in the fourth quarter of 2019 but then fell 12% in Q1 and another 10.3% in Q2.  Converting these figures into annualized changes, profits declined at a 37.6% rate in the first half of 2020, versus a total 2-quarter drop of 19.2% for real GDP.

“In other words, profits dropped faster than the overall economy. Look for this process to go in reverse for the third quarter and beyond.”

Wesbury believes this is normal – profits usually grow faster than the economy in the early stages of economic recoveries. He also said labour share of GDP - wages, salaries, and fringe benefits - surged in the first half of the year as firms reduced payrolls rapidly but not quite as rapidly as production fell.  Many employers realized they couldn’t afford to layoff workers who they figured they would want and need when the crisis passed.  This means less of an increase in payroll costs as the economy heals. Many firms have also trimmed other costs, like travel and office.

Wesbury said: “Bottom up forecasters have been predicting record levels of overall corporate profits next year, and we concur from a top down approach.  Bottom line, the rise in stocks is not based on fantasy, but the fact that profits and low interest rates continue to reflect undervalued equity prices for most industries.”