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The Stock Market–Real Economy “Disconnect”: A Closer Look

Summary:
Andrew Chen, Markus Ibert and Francisco Vazquez-Grande in this Federal Reserve research analyse the disconnect between Stock markets and real economy: Between March and September 2020, broad equity price indexes around the world experienced a historic rally. Although this rally followed a significant decline in stock prices, it appears difficult to explain due to continuing concerns about the global pandemic and national economies running far below their potentials. However, stock prices are forward looking and reflect expectations about profits and discount rates even as far as decades ahead. In this note, we construct assets that are more comparable to near and medium term economic conditions using data on domestic and international dividend futures and the cross section of

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Andrew Chen, Markus Ibert and Francisco Vazquez-Grande in this Federal Reserve research analyse the disconnect between Stock markets and real economy:

Between March and September 2020, broad equity price indexes around the world experienced a historic rally. Although this rally followed a significant decline in stock prices, it appears difficult to explain due to continuing concerns about the global pandemic and national economies running far below their potentials.

However, stock prices are forward looking and reflect expectations about profits and discount rates even as far as decades ahead. In this note, we construct assets that are more comparable to near and medium term economic conditions using data on domestic and international dividend futures and the cross section of U.S. stock returns. We find that the disconnect is driven by gains in the market value of long-term (beyond five years) dividends. In contrast, the value of corporate dividends for the next five years remains far below pre-pandemic levels.2 We provide additional evidence supporting this theme using a cross section of U.S. stocks sorted on price-dividend ratios and equity duration, as well as evidence from dividend futures for a cross section of international equity indexes.

Taken together, our evidence suggests that financial markets remained connected to near and medium-term economic conditions during the 2020 summer rally. Specifically, dividend futures prices remained depressed even at five-year horizons both domestically and internationally, and the recovery in stock prices between the middle of March and September has largely been driven by an increase in the prices of far-dated dividend claims as well as high duration stocks.

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Amol Agrawal
I am currently pursuing my PhD in economics. I have work-ex of nearly 10 years with most of those years spent figuring economic research in Mumbai’s financial sector.

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