• 2020 has been defined by a material disconnect between stock prices and the economy
  • However, McKinsey says the stock market is “neither irrational or erratic”
  • The consulting firm cited three reasons why that disconnect is grounded in reality

On September 3, Australia reported a decline in GDP for the June quarter of seven per cent — the largest fall on record.

And on the same day, the ASX200 rose steadily to push further above the 6,000 level.

(The local index did lose some ground in September, but has since climbed back to new post-COVID highs).

It was a similar story in the US, where Q2 GDP plunged more than 30 per cent, only for the S&P500 to hit a new all-time high on September 2.

That disconnect has raised concerns that stock prices are now driven mainly by speculation, unmoored from valuation fundamentals.

However, analysts at McKinsey have cited three reasons why the divergence actually makes sense.

Long-term view

By their nature, share markets are forward-looking beasts.

So in that context, when Australia’s stats bureau releases Q2 GDP data more than two months after the fact, in many respects markets have already moved on.

And valuations are derived via a judgment call on the value of future cash flows, not historical income.

To illustrate, McKinsey posited an extreme hypothetical where stock profits fall by 50 per cent over the next two years.

After the two years, profits (and profit growth rates) return to pre-crisis levels.

Even in that (extreme) scenario, when extrapolated out over the next 10 years the overall present value of the stock market would decline by just 10 per cent.

Winners and losers

Although markets have risen strongly post-COVID, the rally hasn’t been a rising tide that lifts all boats.

For example, Australia’s red-hot BNPL sector has surged as investors react to strong top line growth and changing consumer patterns.

However, the big four banks — hamstrung by lower margins as interest rates plummet — are still well off their pre-COVID highs.

McKinsey said it’s a similar story in the US, where stocks in oil and gas, banking and travel have suffered.

And at the same time, companies in technology, media and telecommunications (TMT) are doing better than they were before the pandemic.

That shift is even more pronounced when considering the outsized share of the market big tech players now make up.

“Alphabet (Google), Amazon, Apple, Facebook, and Microsoft collectively account for 21 per cent of the market’s value — up from 2 per cent in 1995 and 16 per cent at the beginning of 2020,” McKinsey said.

Without the TMT sector, US stocks would have seen zero growth in 2020. Instead, the market is up ~9pc.

Stocks are not the real economy

When assessing which companies have been belted the hardest by COVID-19, some familiar sectors spring to mind — restaurants, gyms, retail stores and service providers (such as hairdressers).

And taken in aggregate, McKinsey said they all generate lots of jobs and make a material contribution to GDP growth.

But at the same time, they also “account for a smaller share of the market, and often have few listed companies”.

So in that context, it stands to reason that listed stocks can outperform even when the real economy is stuck in reverse.

Looking ahead, McKinsey said the outsized weighting of big tech could pose a risk to stocks if investors dial back the growth rates they currently have ascribed to those companies.

However, “the numbers show that the US stock market is neither irrational or erratic”, McKinsey said.

Rather, “the specific mix of industries in it has played a big role in making it more resilient than the economy as a whole”.