Most people assume that there is a direct link between the state of the economy and the stock market, and most of the time they would be broadly right.
When the economy is growing and businesses are making money, share prices typically rise, too, but right now that connection looks broken.
Last year was an unprecedented disaster for the global economy, with some developed countries seeing their gross domestic product fall by a fifth amid the Covid-19 pandemic. That is the kind of drop you only see in a major war.
Yet, instead of collapsing, share prices in many countries ended the year higher, in many cases hitting record highs.
For example, the MSCI World Index grew 15.9 per cent in 2020, when common sense suggests it should have crashed by an even greater amount.
Other markets fared even better. MSCI China jumped 29.67 per cent and MSCI USA climbed 21.37 per cent.
That is a massive disconnection as businesses are forced into lockdown, consumers are squeezed and unemployment climbs.
There is an easy answer to the conundrum. Central bankers and governments responded to the Covid-19 pandemic by pumping trillions of dollars into fiscal and monetary stimulus, and that is boosting asset prices, from shares to property to Bitcoin.
If the US Federal Reserve hadn’t intervened, the stock market crash we saw in March would only have been the beginning of the meltdown. Effectively, politicians and central bankers are backstopping share prices.
Markets are also betting the vaccine breakthroughs will liberate the world from lockdown this year, and fire up the mother of all recoveries.
Private investors who are wondering whether to pump more money into the market face a tricky question. Are stock markets getting carried away and pricing in a recovery that may not happen, daring you to invest at today’s elevated prices?
Richard Hunter, head of markets at platform Interactive Investor, says “Main Street” and “Wall Street” are always slightly out of sync. “Wall Street is looking forward to company earnings and the general economic outlook at some future point, whereas Main Street focuses on where jobs and growth are today.”
Chaddy Kirbaj, vice director at Swissquote Bank in Dubai, says stimulus has further widened the gap between the stock market and real economy. “The money has mostly gone to the big financial institutions rather than, say, agriculture, industry and trade. Many are using the cash to buy back their shares, which boosts stock values but does little for consumers.”
The danger is that this is creating asset bubbles, such as Bitcoin and the Reddit-fuelled GameStop rally, and Mr Kirbaj anticipates further euphoria. “Traders are likely to target similar assets as they continue their fight against the Wall Street establishment.”
He urges investors to remain cautious, and avoid diving into cheap assets without doing due diligence or understanding how they work.
One thing has not changed. “You should diversify by investing in a blend of countries, markets and sectors, via shares or exchange-traded funds,” Mr Kirbaj says.
Vijay Valecha, chief investment officer at Century Financial, reckons markets are at record highs because the prospects for investors look bright.
In 2020, earnings per share across the S&P 500 index of blue-chip US stocks fell to $124.68, a drop of 18 per cent from $152.25 in 2019.
This year and next look much better, with earnings forecast to hit $169.03 in 2021 and $196.15 in 2022. “The Nasdaq technology index is also expected to grow handsomely,” Mr Valecha says.
With company earnings set to rise, stock valuations do not look excessive and more stimulus is on its way.
Mr Valecha adds: “President Biden’s planned $1.9 trillion pandemic rescue package could further bump up corporate profits.”
Mr Hunter agrees that the outlook is becoming brighter. “When economies recover, pent-up demand should boost beaten-down sectors such as travel and tourism, banks, oil companies and mining stocks.”
Laith Khalaf, financial analyst at AJ Bell, says shares are the best way to play the recovery. “By lowering interest rates on cash and bonds, central banks have left investors nowhere else to go.”
He warns the road to recovery could be bumpy. First, there is the euphoria issue, as seen with Bitcoin and GameStop. “What isn’t clear is whether this is limited to small pockets of investors, or symptomatic of a wider disregard for risk.”
Some fear markets have got carried away. Stock market historian Jeremy Grantham has warned the “long, long bull market” that began after the financial crisis in 2009 has finally matured into a “fully-fledged epic bubble”.
Extreme overvaluations, explosive price increases and “hysterically speculative investor behaviour” are creating what he predicts will prove to be “one of the great bubbles of financial history, right along with the South Sea bubble, 1929, and 2000”.
Mr Khalaf acknowledges these concerns and says anything could happen from here. “The market may rise 20 per cent or fall 20 per cent. It’s that kind of year.”
Given the uncertainties, he says investors should hedge their bets by drip-feeding money into stocks gradually.
As ever, the investment world is split into optimists and pessimists. So where should these two types invest today?
Optimists
Mr Khalaf says optimists could benefit from the recovery by investing in a low-cost global index tracking ETF.
The iShares Core MSCI World UCITS ETF and Vanguard All-World UCITS ETF invest in thousands of stocks in different countries across the world, spreading your risk.
Mr Valecha says optimists who believe the economy will open up this year could buy the US Global Jets ETF. “This invests in US and international passenger airlines, aircraft manufacturers, airports and terminal services companies.”
The airline industry remains vulnerable to further lockdowns, as many countries close their borders, so make sure you understand the rewards as well as the risks.
Mr Valecha says the shift to clean energy also provides opportunities for optimists, and tips the Invesco WilderHill Clean Energy ETF.
Demand for lithium is expected to triple in the next five years as the metal is needed for electric vehicles. “The Global X Lithium & Battery Tech ETF will help you ride this trend,” Mr Valecha adds.
Dzmitry Lipski, head of funds at Interactive Investor, tips the Baillie Gifford Responsible Global Equity Income Fund, which pursues sustainable income and capital growth by investing responsibly in global equities, while excluding less ethical industries such as tobacco and alcohol. “Top holdings include Procter & Gamble, Roche, Microsoft and Nestle.”
Pessimists
If you are feeling cautious or even outright pessimistic, Mr Khalaf suggests putting some of your money into a gold ETF, such as WisdomTree Physical Gold. “This acts as a hedge against catastrophe, but should account for no more than 10 per cent of your portfolio.”
Alternatively, he suggests a conservatively run multi-asset fund like London-listed RIT Capital Partners.
Mr Kirbaj tips a “less aggressive” ETF that still offers higher growth potential. “Water is one of the world’s most precious asset classes and the iShares Global Water UCITS ETF gives you exposure to 50 of the largest global companies in this area.”
Mr Lipski highlights the Capital Gearing Trust, which aims to preserve investors’ capital while beating inflation over the longer term. “It is a good core holding due to its defensive stance and diversification across bonds, equities and property, with small holdings in infrastructure, gold and cash.”
The trust also offers protection against inflation, which could make a comeback as stimulus reflates the economy, Mr Lipski says.
