The stock market's recent surge makes sense if you actually look at the US economy - Business Insider

Business Insider

A number of stories have emerged pointing out a supposed disconnect between “Main Street” — the US economy which is being hit by the pandemic — and Wall Street — which has seen stocks rally.But there are signs that the US economy has already bottomed and activity is starting to come back.And since equities are forward looking, the gradual recovery of the stock market actually makes sense.Does that mean things in the economy are good？ Of course not. But stocks tend to get better before the economy is “good.”Neil Dutta is head of economics at Renaissance Macro Research.This is an opinion column. The thoughts expressed are those of the author.Visit Business Insider's homepage for more stories.

With the stock market rallying sharply off its March 23 low, the usual cries have started: stocks are missing the economic reality, they're whistling by the graveyard, they're completely divorced from economic fundamentals.In the last week: the Economist claims “A dangerous gap has opened between America's stock market and the real economy.” Noted economic pundit Mohamed El-Erian argued that the “Market keeps distancing itself from the economy.” But that is not so surprising early on. Admittedly, current economic conditions are poor. Economic output has cratered, leaving widespread joblessness in its wake. But this does not necessarily mean equity prices should be substantially lower than they are now. The US equity market is not about whether economic conditions are good or bad. Rather, what matters is whether conditions are improving or getting worse.

Today, the evidence is mounting that economic conditions, while far from good, are starting to improve. This is why stocks are up.Hitting the bottomGenerally speaking, economic conditions can be thought of in two ways: momentum and level of activity. The momentum in the economy represents how quickly conditions are changing in relation to the past while level of activity in the economy measures how far conditions are from their historical averages.For instance, the US can add thousands of jobs — that shows positive momentum — while the unemployment rate — the level — remains well above its historically average. Momentum needs to be positive in order for the level of activity to improve. Consider the period following the 2009 recession. It took many years for the level of economic activity to return to potential, as the chart below demonstrates. Even as potential growth repeatedly got revised down, the level of growth hit potential sometime in 2017. Still, this period was an especially good one for stock prices even if for many, it “didn't feel like” a recovery.

Neil Dutta

Today, the evidence is mounting that the level of activity has bottomed – that is, conditions are not getting any worse – and the momentum in the economy has picked up somewhat.

Motor gasoline demand bottomed for the week ending April 10 and has been climbing, retracing about one-third of its decline since mid-March. Mortgage purchase applications also bottomed for the week ending April 10, similarly recouping about 40 percent of its plunge since mid-March. Passenger screenings at our nation's airports are also on the mend. The count is now about double the April 14 low, but still 93% off its year-ago level. Notice that the timing of this improvement precedes the formal lifting of shelter-in-place orders for nearly all states. Thus, it stands to reason that there is room for at least some improvement once formal lockdowns end.Of course, there are risks to the outlook. Double-dips in the economy are usually about policy choices. Almost always, double-dips are about policy choices after a recovery starts.For example, in 1982, the economy saw a deep recession after a brief recovery because the Federal Reserve tightened interest rates to take on inflation. In the case of the coronavirus pandemic, the policy choice would be to shut parts of the economy down if the virus spread gets worse.

That said, markets have rallied for good reason and the message from stocks is not all that different from what I see in the economy. Economic conditions are no longer getting worse and the re-opening is likely to be measured. Still, we see modest improvement across a range of metrics.Does that mean things in the economy are good？ Of course not. But stocks tend to get better before the economy is “good.”

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