One of the most curious things happened in 2020 – the stock market surged to all-time highs during a pandemic. What is even more interesting is the aggressiveness of the market move and the overall widespread of the buying phenomena.
The theory of the business cycle tells us some interesting things regarding economic growth in a developed market. For example, the assumption is that the economy’s long-term growth rate is always present. It is only the dynamics above or below the long-term growth that drive boom and bust periods.
Imagine a chart with x and y axis. Next, draw a positively sloped line (i.e., from left to right). That is the long-term economic growth. Deviation from this line represents economic expansions and contractions.
A key challenge to economists is to correctly identify the peak of an expansion or the bottom of a contraction. For this, leading economic indicators exist – building permits, new factory orders, etc.
Few people are aware that the broad stock market is a leading indicator in the theory of the business cycle. In the United States, the S&P 500 index is the benchmark for the broad market. It is supposed to lead the business cycle by three to six months.
Is the Stock Market Pointing to a Strong 2021 Economic Growth?
There is a lot of talking in the market that the strong equity market performance during the pandemic was caused by the tech sector. It very well may be – the Nasdaq 100 outperformed.
However, the S&P500 did manage to put an all-time high too. Hence, the logic behind the stock market leading the business cycle remains valid.
The chart above shows the trading volume at five different brokerage houses during the month of April in the last decade. Nothing strange and unusual about it – until April 2020 came. Or, until the pandemic hit the Western world. We can call this a sample of the overall trading activity seen in the U.S. stock market.
What if the stock market told us that the coronavirus recession would not last as long as many feared? For a leading indicator, it turns way before the economy turns.
The pandemic created the quickest drop from a bull to bear market in history. However, it was followed by the fastest rise from a bear to a bull market in history. On the bigger timeframes, the stock market reaction during the pandemic looks like a small glitch.
Can it be that stocks anticipated a quicker than expected back to normal scenario?