The stock market isn't the economy.

You've probably heard that saying before, but it's never been as true as it is today. The U.S. economy is reeling in a crisis of proportions not seen since the Great Depression. Twenty-two million Americans have filed for unemployment in the last four weeks, effectively erasing 10 years of job gains. Retail sales plunged in March, and small businesses exhausted the $350 billion in funding from the Paycheck Protection Program in less than two weeks.

However, the stock market is suddenly soaring. After plunging for about a month while the coronavirus outbreak spread to Europe and then the U.S., the S&P 500 suddenly reversed course after hitting bottom on March 23. Since then, the broad market has surged by as much as 31%, posting record gains along the way as the index had its best week since 1974 earlier in April.

Investors seem to be saying that the worst over. The water's safe to play in again. What gives?

While it's true that the worst of the coronavirus pandemic may have passed, with daily new cases having seemingly peaked in many areas and some states beginning to reopen their economies, but it's wrong to assume that the crisis will gradually fade from here as there are still plenty of unknowns, including the possibility of a second wave of infections and how consumers will behave when stores and restaurants are open again.

Given the economic shock the country is experiencing, it seems baffling that stocks are rising. After all, the market doesn't offer an explanation for its movements, but here are three reasons that help explain the sudden bifurcation between the stock market and the American economy. 

Stock pages in the newspaper

Image source: Getty Images.

1. The stock market is just one piece of the economy

It's easy to think of the stock market as a stand-in for the economy. It's the most readily available indicator we have for the economy, and reports of where the Dow is abound on news outlets every day. Over the long term, the stock market's performance does tend to correlate with the economy, but rather than a measurement of the strength and size of the overall U.S. economy, the stock market is really an indicator of corporate profits and how fast investors expect them to grow. That window into the economy is smaller than you might think. Less than a third of Americans work for publicly traded companies, and much of consumer spending, such as rent, goes to individuals or small businesses, which the stock market doesn't directly account for. 

What's good for corporate profits doesn't always conform with what's good for the economy, either. For instance, Wall Street often cheers when a company announces layoffs, seeing it as a sign of cost-cutting and increased profitability, even though the loss of jobs is a negative for the greater economy. Similarly, Wall Street is generally a fan of share buybacks, though the tactic has been criticized for enriching management and inflating a company's stock price, rather than the company's using that money to invest in actually growing its business by hiring new employees or opening a new plant, for example. 

What's unique about the current economy and the recent market rally is that tech stocks, which tend to have relatively few employees, have surged, while the consumer discretionary sector, which is made up of retailers, restaurants, travel companies, and others that employ tens of millions of Americans, is getting crushed.   

Netflix (NFLX 3.03%), for example, has been one of the big winners of the market's rebound as shares have jumped about 50% from their March lows, and the video streamer is now worth nearly $200 billion. However, Netflix has just 8,600 full-time employees, meaning the company is worth more than $20 million per employee.  

On the other hand, Macy's (M -1.44%), whose shares have been pounded during the crisis, has approximately 123,000 employees, most of which are now furloughed. Macy's generated more revenue than Netflix did last year but is valued at less than $2 billion, or about $1,600 per employee. In other words, Macy's has just 1% of the impact on the stock market that Netflix does, but considering that it has many more employees, it generated more in revenue last year, and it occupies 120 million square feet of retail space (and is often a mall anchor), the retailer likely has significantly more influence on the health of the U.S. economy than Netflix.

Members of Congress at a swearing-in ceremony

Members of Congress at a swearing-in ceremony. Image source:

2. The government is providing a backstop

Without government assistance, the economy could be on the verge of another Great Depression. Many Americans live paycheck to paycheck, and small businesses often only have a month or two of cash flow to survive a sudden stoppage like the one the pandemic has caused. Without help, individuals would quickly sink into poverty, and businesses would go bankrupt. However, Congress and the Federal Reserve have stepped up several times to help shore up the economy and make a recovery as smooth as possible, and investors have responded enthusiastically each time the government has offered help.

For instance, stocks surged immediately after hitting bottom on March 23 as the CARES Act made its way through Congress, and then into law after President Trump signed the bill on March 30. The estimated $2.2 trillion relief package includes direct payments to individuals, enhanced unemployment benefits, relief for small businesses, a bailout package for airlines, and loans for other affected big businesses. Congress is working to pass another bill to provide additional funding, including more loans for small businesses.

Shortly after the crisis began roiling the economy, the Federal Reserve sprang into action lowering its benchmark federal funds rate to 0% to 0.25%, making borrowing more affordable. The central bank has also rolled out a substantial quantitative easing program, buying bonds in order to encourage lenders to keep lending and maintain confidence in the banking system. On April 9, the Federal Reserve pledged to buy up to $2.3 trillion in loans to enhance liquidity in the credit market, including junk bonds, which helped lift shares of struggling companies such as Ford, as well as retailers and restaurants. 

At this point, investors seem to be confident that the government will do what it takes to stabilize the economy and accelerate the recovery. Though the efficacy of its actions is debatable, they have helped lift a number of stocks that were at risk of going bankrupt, boosting the broader market's recovery.

A man looking at a large board displaying various charts and graphs

Image source: Getty Images.

3. The stock market is forward-looking

The stock market is a leading indicator for the overall economy. Investors are betting on where the economy is going, not where it's been, and the gains in recent weeks seem to signal that the worst, at least in terms of the fear factor that drove much of the initial selling, is behind us.

In the last recession, for example, the market bottomed out in March of 2009, several months before for the unemployment rate peaked in October of that year, or before GDP returned to growth in the third quarter of 2009. 

In other words, during a bear market or a recession, stocks begin to bounce back once a recovery becomes visible, which is before it actually starts. In the market recovery, low stock prices help lure investors back in, incentivizing the risk-taking incumbent in buying stocks in the midst of an economic crash. With its recent comeback, the market seems to be signaling that the long-term economic forecast for corporate profits has improved significantly in the last month. Investors believe that the worst possible outcomes from the crisis have been averted as the government has stepped in and new daily coronavirus cases in the U.S. have plateaued.

However, the S&P 500 is already back at levels it saw as recently as August 2019, when the U.S economy was enjoying a record economic expansion, unemployment was near an all-time low, and COVID-19 didn't yet exist. That means the market's sudden recovery may be reason for caution. Today, the unemployment rate is unofficially in the double-digits, and even if lockdown orders are lifted, the virus will continue to be an impediment to business and normal daily life for the foreseeable future -- probably until a vaccine is invented.

Before the last recession, S&P 500 profits peaked in Q2 2007, and they didn't surpass that level for four more years, until Q2 2011. With such a quick recovery in stocks now, investors seem to believe that corporate profits will top 2019 levels as soon as next year. According to the S&P, estimates call for trailing-12-month earnings per share to be higher by Q3 2021 than they were in Q4 2019, and quarterly profits should recover by the fourth quarter of this year. To these prognosticators, the current crisis seems to be nothing more than a blip.

However, there's a whole lot of uncertainty between now and then. Whether profits can recover that fast depends on if we can control the virus and ensure the current period of surging unemployment is short-lived. Even if that happens, consumer confidence is unlikely to be where it was a few months ago, before the pandemic was a reality.

With record-shattering unemployment claims, a global pandemic afflicting millions, and corporate earnings guidance going out the window, investors are in uncharted territory, here, and can't make their usual assumptions about the direction of the economy. That means the stock market's reliability as a leading indicator for the economy is fundamentally broken.