The COVID-19 pandemic is sometimes called “The Great Equalizer.” It’s an “equalizer” only in the sense that no one is safe and that a lot of people die. But its effect is very unequal in that inequalities, whether in terms of income status, race, or class, that have been present prior to the pandemic, have been exacerbated by this pandemic.
Many workers in the upper income classes have employment that enables working from home via internet. In contrast, many jobs with lower incomes involve service jobs — health and home care, clerks in pharmacies and supermarkets, janitorial services and many others that cannot be done at home.
A disproportionate number of deaths are suffered by African-Americans and other minorities. This can be explained by their high rates of employment in service jobs, and the hard fact that many of these victims have suffered pre-existing conditions that make them more vulnerable to death by the virus. This latter, in turn, goes back to the fact that many of these victims have long experienced inadequate access to affordable health care compared to those with higher incomes.
The pandemic has also disproportionally hit small business relative to big business.
Of particular note is the relatively strong performance of financial markets in the face of unemployment not seen since the Great Depression. How can this be?
The simple answer is that while financial markets are related to the real economy, they are not the real economy. Fluctuations of financial markets, even periodic highs and lows, have little effect on typical workers, and even on many small businesses. While many Americans own stocks, many through contributions to retirement funds, some 80% of stock market wealth is owned by about 10% of Americans.
The pandemic initially set off a steep drop in the Dow and the S&P 500 indices, with the S&P 500 losing approximately one third of its value form its 2020 high to its March 26 low. Since then, the S&P 500 has regained over one third of that loss and is off by less than 10% since Jan. 1. The Dow has already regained over half of its losses. As of this writing, the Dow is only off by about 12% since Jan. 1. These clearly are strong numbers compared to the devastating unemployment numbers, business losses of Main Street, and increased dependence of Americans on food banks, especially by people who never dreamed they could be in this situation.
Let’s attempt to explain — not justify — but explain this paradox.
Financial markets are said to be forward looking, reflecting expectations of the future. To the extent that there is some economic logic to financial markets, stock prices reflect the present value of expected future returns, returns including dividends and the expected gain in price of securities. At the risk of sounding overly technical, the present value of future returns depends on the discount factor applied. A high discount rate diminishes the value of future returns relative to a low discount rate. A low discount rate is more tolerant of returns in the future.
While the typical investor does not go through this technical analysis for investment decisions, the practical effect is that with low interest rates throughout the economy, stock dividends are relatively attractive compared to other investments, justifying a higher price for stocks. This is one reason why American presidents favor the Fed to keep interest rates low, and is one reason why stocks have performed well ever since the Great Recession of 2000-08.
Additional reasons bandied about for the stronger than might be expected financial markets have to do with the components of the indices.
The Dow consists of a mere 30 large corporations. The S&P 500, as the name implies, consists of 500 of the nation’s largest corporations. The Dow is weighted by the price of each corporation’s share of stock. In contrast, the S&P 500 is weighted by capitalization, the total value of each corporation’s outstanding stock. As a result, those companies of the DOW with the highest stock price, and those corporations of the S&P 500 with the largest capitalization, will have disproportionate effects on their respective index.
Let’s take a closer look.
Of the 30 DOW stocks, Apple, Inc. has the highest priced stock, in the $300 dollar range. In contrast, large corporations with lower priced stocks, Walgreens and Exxon for example, are priced in the $40 range. Hence, performance of Apple, Inc. will weigh more heavily in the index than other large corporations with lower priced stocks. Of the 30 DOW stocks, the six priciest stocks, Apple, Inc., United Health Care, Home Depot, Visa, McDonalds, and Microsoft, account for about 40% of the performance of the total index. And whaddaya know — these are among the corporations that one would expect to hold up reasonably well during this economic downturn, compared to banks and transportation, for example. Regarding the S&P 500, the corporations with the largest capitalization, hence exerting the largest weight in the index, are Microsoft, and Apple, Inc. Again, these are two corporations producing products and services expected to remain in high demand during a pandemic such as this.
Although one can quibble over the importance of these points, they are a partial explanation for the unexpected strength of the two stock indices.
The broader explanation for financial markets holding up as well as they have gets back to the proposition that markets reflect the future, not the past. That is, the expectations investors have for the outcome of this pandemic over summer and coming autumn. If we are “over the worst,” and if the Fed adopts policies that keep the financial system functioning, and if the congress and president manage fiscal policy to keep individuals and businesses solvent, some optimism for the markets may be justified.
That’s a lot of big “ifs.”
Financial markets operate as much by emotion, as by straight economics and, now, the future course of this pandemic. We are still in uncharted territory.
— John Waelti of Monroe, a retired professor of economics, can be reached at jjwaelti1@tds.net.
