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A Momentous Occurrence

From Baltimore – Something momentous occurred in financial markets on May 7, and it may portend an important transition in the economy and financial markets.

Yet this event went largely unnoticed by investors and market analysts. You didn’t hear much about it in the media either (most of that group is determined to peddle only doom and gloom).

What happened? Well, the Nasdaq Composite Index went positive for the year.

And as of this writing, the Nasdaq – which tracks more than 2,500 stocks – is up more than 2% since January 1.

It’s not a lot, but it’s pretty impressive in a year when the economy fell apart and the stock market cratered.

And it compares very favorably with the other major market indexes. The S&P 500 Index is down about 10% year to date, and the Dow Jones Industrial Average is down more than 15%.

A chart showing the Nasdaq going positive versus other indices like the Dow and the S&P 500.

So What?

So, you’re asking, what’s the big deal? Different indexes track different stocks, right?

Right. But looking at what they track tells a story and may predict the future.

The S&P 500 tracks the 500 largest U.S. stocks, or about 70% of all publicly traded stocks. So it’s the best and broadest gauge of the overall market and economy, basically.

The Dow tracks 30 heavily traded blue chip companies, the largest in their respective industries. These include major manufacturers like Caterpillar (NYSE: CAT) and Boeing (NYSE: BA), oil behemoths like Chevron (NYSE: CVX) and Exxon Mobil (NYSE: XOM), and retailers like The Home Depot (NYSE: HD) and Walmart (NYSE: WMT).

There are a few tech firms in the Dow, but they make up less than 20% of the index. Healthcare, consumer staples and industrials are heavily represented.

The Dow is also the oldest market gauge; it was invented by Charles Dow in 1896.

The Nasdaq Composite Index, by contrast, is relatively new. It was launched in 1971.

Unlike the other two major indexes, the Nasdaq skews heavily toward a single industry: tech. Technology and telecommunications stocks make up more than half of it. The next biggest industry is consumer services, at about 20%. Industrials and energy together account for less than 7%.

A chart of the Nasdaq stocks weighted by sector.

The Nasdaq has become popular in recent years because it is so heavily weighted toward tech sector and innovative companies. And those companies, from Microsoft (Nasdaq: MSFT) to Apple (Nasdaq: AAPL) to Amazon (Nasdaq: AMZN), as well as many smaller tech firms, have become much more prominent over the last few decades.

And there’s the hint about the future.

“The post-pandemic world will be much different from the world before it,” Chief Trends Strategist Matthew Carr wrote last week. (By the way, the Nasdaq’s outperformance didn’t go unnoticed by Matthew.)

I couldn’t agree with Matthew more. As I wrote in April, this pandemic will leave permanent changes in its wake. It will alter how we think about the world, how we work and play, and how we interact and conduct commerce.

It will also destroy many businesses and create others.

We’re witnessing the destruction phase now. Just in recent weeks we’ve seen bankruptcies by several major retailers, including J. Crew, J.C. Penney and Neiman Marcus. Gold’s Gym also filed Chapter 11. And the rental car firm Hertz (NYSE: HTZ) and energy pioneer Chesapeake Energy (NYSE: CHK) are on the brink.

There will be many more such failures as the pandemic and economic downturn play out.

But if there’s a silver lining to economic contractions, it’s this: They accelerate the ongoing process of pushing aside outdated and inefficient business models and conjuring innovative and more productive ones to take their place.

Austrian political economist Joseph Schumpeter wrote about this almost 80 years ago. In his 1942 book Capitalism, Socialism and Democracy, Schumpeter had much to say about the never-ending process of “creative destruction.”

“Economic progress, in capitalist society, means turmoil,” Schumpeter wrote.

Schumpeter saw these periods of turmoil – economic contractions in particular – as fertile ground for entrepreneurs and innovators to bring new industries into the world or radically overhaul and improve existing ones.

New Opportunities

Now, not for a moment am I attempting to minimize or dismiss the real pain this recession is causing so many innocent individuals. These workers and business owners are victims of this pandemic that forced the economic shutdown and closed restaurants, malls, shops and businesses everywhere.

Instead, my point is merely one of optimism in trying times: Untold numbers of new business models will arise from the ruins of this global catastrophe. And they will provide new and potentially better opportunities for workers, entrepreneurs and investors.

And that brings us back to the Nasdaq. Markets convey the collective wisdom of all the investors involved in them, and this wisdom is about what the future holds for us. Individual investors may not know it, but they’re part of this signaling mechanism.

By diverting their capital away from other sectors and into technology companies, investors are saying they believe those are the businesses that will put that capital to best use going forward. The tech sector is where innovation and dynamism will be the greatest, the Nasdaq’s outperformance is telling us.

We should be listening closely.

Good investing,

Matt


About

Matt has worked as an editorial consultant to the International Monetary Fund, the World Bank, the Economist Intelligence Unit and other global macro-institutions. He wrote about markets and economics for U.S. News & World ReportBloomberg News and Investor’s Business Daily, among other publications. He also worked for several years as head of political economy for a Financial Times-owned macroeconomic consulting firm, advising hedge funds around the world. Matt’s claim to fame is that he’s interviewed two U.S. presidents and has spoken with five Federal Reserve Chairs from Paul Volcker through Jerome Powell. Matt also served as The Oxford Club’s Editorial Director for two years.

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