It’s been quite a roller coaster as of late when reading financial news. For example, recently, within the spate of a few hours, CNN Business posted an article outlining concerning unemployment numbers and a separate article discussing the stock market hitting record highs.
How do those two seemingly incompatible things make any sense? How can stocks possibly be a good investment if companies are struggling? Why are investors making money if so many people are unemployed? Furthermore, how can these choppy waters be navigated, both by people concerned about their employment and those concerned by their retirement savings?
Stock market basics
One major reason that stocks have value is that they represent a little slice of the future earnings of a company. When a company earns money, it pays out a small amount of those earnings to each shareholder, called a dividend. If a company earns less money, that dividend is going to be smaller, and thus a share of the stock has less value.
The stock market is where people go to buy and sell shares of stock, and the value of a share of a stock goes up if there are more buyers than sellers. The sellers will keep raising the price as long as buyers keep buying. On the other hand, the value of a share of stock goes down if there are more sellers than buyers. The sellers will keep dropping the price until they find buyers.
When bad news comes out about a company and it becomes clear that a stock has less value than was previously believed, people will want to sell it. After all, it looks like they’re going to get fewer dividends out of it than they thought. At that point, there are usually more sellers than buyers, so the price goes down.
The first thing to understand in this picture is that the state of the stock market at any given moment is much more representative of the future, not the economy at that exact moment.
The stock market reflects companies, not individual people
If we step back for a minute and look at the big picture, it’s clear that if the stock market goes up, investors must be confident about a good future for many companies. That usually happens when they peer into the future and see widespread good news for those companies.
That does not necessarily translate into good news for individual people. Something that’s bad news for an individual person might be good news for a company and vice versa.
Here’s a clear example. Imagine that a company’s management decides that the company will be more healthy if 10% of its workforce is cut. It’s going to be terrible news for those who are let go, but the company as a whole is likely to be reporting more profit than before — after all, it just reduced the money it’s paying to its workers by 10%. As long as it doesn’t lose much income by doing this, it’s good news for the company, even though it’s bad news for the workers.
Remember, the stock market operates on what’s good or bad for the company, not the workers. If the stock market is going up, then investors are seeing an overall set of good news for companies, even if the news from the perspective of individual workers might be bad.
The unemployment rate reflects individual people, not the health of companies
Even as the stock market looks ahead to a bright future, today’s reality for many workers is a dismal one. The unemployment rate is currently quite high and is forecasted to remain there for at least another year or two, with some areas affected much more heavily than others. Areas where the economy focuses on tourism and retail are affected very heavily and will remain so until those sectors return to some semblance of normal.
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This is because, in the moment, individual businesses need to make choices that ensure survival, and this is particularly true of smaller businesses. Small businesses — particularly restaurants, bars, hotels and retail — are struggling to stay afloat, and that often means shedding workers during shifts where the customer base just isn’t very strong. Small businesses employ roughly half of American workers, and they’re not reflected in the stock market at all because they’re not publicly traded companies.
So, why are these two things happening at the same time?
3 reasons why the stock market is doing well while unemployment is high
The Federal Reserve set low interest rates
When most businesses need to borrow money, they turn to banks. When banks need to borrow money, they turn to the Federal Reserve. Thus, the Federal Reserve has a strong hand in setting the interest rates that banks offer to businesses. When the Fed enables banks to borrow from them at extremely low interest rates, banks can then turn and offer very low interest rates to businesses that borrow from them.
This means that businesses will be able to stay afloat much more easily than they would be able to if interest rates were high. If a business needs to borrow some money, they’re much more likely to be able to repay it and thrive if they borrow money at a 3% interest rate than at a 10% interest rate.
Thus, the Federal Reserve publicly committing to keeping interest rates low for a while indicates that businesses will be able to borrow money at low interest rates for the foreseeable future, which means that more will survive and more will thrive than might otherwise happen. That’s good news for most businesses and increases the overall confidence investors have in buying stocks.
This is enabling many smaller businesses to survive for the time being, but not thrive. They can keep their doors open and retain some employees, but they’re still left with the choice of letting some employees go for the time being.
A coronavirus vaccine is on the horizon
There are several vaccines for coronavirus nearing approval and production that should be widely available in the next several months. A robust and effective vaccine, used by a sufficient portion of the population, means that many people will be returning to some form of pre-coronavirus behavior sooner rather than later.
That’s a huge boon for industries negatively affected by coronavirus. The travel, tourism, retail and hospitality industries have suffered, and signs that things will return to something approaching the previous normal are very positive signs for the future of those sectors.
Remember, the stock market has already considered what is going on today in those industries, and current rises in price are much more concerned with tomorrow. For those industries, tomorrow looks a lot better than today.
Some large companies are successful during this period
A final factor to consider is that, while some companies have definitely struggled, other companies have actually done really well during this period. Technology companies in particular were in a great position to thrive during an era of social distancing, and they’ve taken advantage of it, selling hardware and software that has enabled people to continue to communicate and work during shutdowns and periods of remote work.
Many investors have sold shares in other companies just to buy shares in technology companies, so as one company’s share value drops, another company’s value rises. This is mostly a phenomenon related to very large businesses. Smaller businesses, as noted earlier, are really struggling right now. Since those businesses aren’t reflected in the stock market because they’re not publicly traded companies, the stock market doesn’t reflect those struggles, nor does it reflect the struggles of the employees that those businesses have had to let go.
Too long, didn’t read?
The key message to take home from all of this is that the stock market is more concerned with the financial health of large companies over individual people and that it is more concerned with the future than with the present. Thus, even in moments when the present situation looks very economically bad for individual people, the future situation for large companies can still look good.
What does that mean for individual investors? Sit tight, like you always have. The best route for almost all individual investors with money in the stock market for retirement is to stick to the plan even through moments of turbulence. You’re likely to miss the top of the stock market if you sell, and miss the bottom when you buy again. Don’t worry about day to day stock prices and stick to your plan.
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Originally posted at https://www.thesimpledollar.com/investing/stocks/why-the-stock-market-is-doing-well-unemployment-high