Don’t confuse the economy with the stock market

The conventional wisdom is that COVID-19’s damage to the economy is severe and uncertainty clouds the path to recovery: with the economy in peril, surely the stock market should follow.

03 Jul 2020

Following the ASX 200’s sharp rebound (+31% from the trough, now -16% from the Feb peak), the market is now fixated on stretched valuations. The conventional wisdom is that COVID-19’s damage to the economy is severe and uncertainty clouds the path to recovery: with the economy in peril, surely the stock market should follow.

Indeed, even when we look at valuations on a two-year forward basis (looking past the disruption from COVID-19), the ASX 200 trades at 17-times, 26% above its 10-year average and 4% below what it was at the recent market peak.

The obvious explanation is that valuations are being pushed higher by structurally lower interest rates and excess liquidity, with QE perhaps the most important factor.

It has certainly drawn the attention of the RBA, which in its June minutes noted “various asset purchase programs and backstop facilities put in place by central banks… had supported investor demand for corporate securities”.

An important distinction, however, is also being forgotten: the stock market is not the economy! There are actually glaring differences between the two. For example, the economy and the ASX 200 diverge considerably when looking at key industries as a proportion of GDP, employment and their market cap weighting:

  • Tourism and education contribute 9% to GDP, but only comprise 0.4% of the ASX 200 by market cap;
  • Mining contributes 10% to GDP, but comprises 20% of the ASX 200 by market cap;
  • Conversely, Financials contribute only 10% to GDP but represent 27% of the ASX 200.

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