Whenever the economy is hit by a mega-crisis, consumption proves to be far more robust than most people expect it to be. Furthermore, financially strong, dominant franchises consolidate market share during such crises. And finally, stockmarkets tend to perform well in the decade following major crises.

In the opening quarter of CY20, stock markets crashed around the world as Covid-19 reared its ugly head. The S&P 500 fell by 20%, the FTSE 100 by 26% and the Nifty 50 in India by as much as 30%. Economic activity first slowed down and then, in the quarter ending June 2020, it contracted sharply. The contraction of real GDP in the EU, US, and India was 3.2%, 9.1%, and 23.9% respectively.

And yet, in spite of this economic contraction and in the wake of the rapid spread of Covid-19, from early April 2020 onwards stock markets rallied strongly. As a result of this, in the six months ending 30th Sept 2020, the S&P500 rose 35%, the FTSE100 rose 3% and the Nifty50 in India rallied by 31%.

So why are stock markets rallying so strongly in the wake of the sharpest economic contraction since the Second World War?

Consumption bounces back after catastrophes

Consumption recovers sharply after economic exigencies. For example, after a debilitating pandemic like the Spanish Flu in 1918-20 (the flu came in three waves), consumption not only recovered to its pre-pandemic levels by 1923 in Europe and in America, but grew consistently at 3% per annum in real terms from 1921 until 1929.

A similar trend could be seen after the second World War. During the war consumption fell by around 2% per annum in the US. But from 1945 onwards consumption rose at 3% per annum in real terms until 1950. This pattern of consumption (fall during the war and recovery post war) was as true for Europe as well.

A similar pattern of consumption recovering swiftly can be seen after the Global Financial Crisis (GFC) of 2008. In fact, consumption of durable goods grew faster in the US after the crisis (at 1% per annum in real terms compared to 0.5% per annum before the crisis). The consumption of non-durables grew at pretty much the same rate (1% per annum in real terms) before and after the crisis.

These three different kinds of negative external shocks yield the same result: consumption, in the long run, doesn’t really get affected. But why would that happen, given the varying nature and intensity of these shocks?

The Permanent Income Hypothesis

The answer lies in Permanent Income Hypothesis (hereon PIH). PIH was postulated in 1957 by Milton Friedman in response to the usual Keynesian route taken by governments to increase incomes in the aftermath of crises. In specific, in response to a crisis, governments are prone to increasing government spending and cutting taxes in the hope of spurring consumption. Friedman’s view was that these measures don’t ensure an uptick in consumption. His PIH theory, on the other hand, states that consumption is a function of the average future income, and not just of the current or immediately foreseeable future.

Friedman observed that human beings are essentially forward-thinkers. Any momentary hardship is considered just as that – momentary. They believe the future will bring better things and in an event of a crisis, it is considered short-lived in context of the broader lifespan of that individual. Therefore, even if people have lost jobs during the crises or have to make do with lower income for the time being, they don’t expect this to continue in the future. Provided their perceived average future income hasn’t wavered significantly, their level of consumption catches up quite quickly once the crisis abate.

Across the world, the robust recovery seen in consumption across countries as diverse as China, the US, and India through the summer and into the autumn, validates Friedman’s PIH and highlights the need for taking a longer term view of the impact of COVID-19 and the stock market.

The stockmarket understands PIH

Like consumers, the stockmarket too looks forward and discounts the future (rather than looking back and fretting about yesterday’s disasters). Hence, as Aswath Damodaran has shown, the stockmarket in period t is discounting the economic recovery which will begin four quarters hence in t+4 (see slide 8 titled ‘Markets are meant to be predictors not reflectors’). Whilst we are not sure how many people in the stockmarket have heard about Friedman’s PIH, the way the stockmarket discounts economic recoveries seems to make sense both in the context of PIH and in the context of how consumption has historically rebounded post a crisis.

In fact, we can use a simple DCF model – and we know investors love simple models – to see how a well-managed company can actually benefit from a exigency like Covid-19. Let’s assume that a market leading widget manufacturer with a dominant franchise is fairly valued at $100 pre-Covid. Assume that this value emanates from the next 20 years of profits – at the rate of $5 per annum – discounted back to the present. Then, Covid-19 enters the picture and impacts the widget manufacturer in two ways. Firstly, it wipes out its current year’s profits completely. Secondly, it financially weakens the said company’s competition relatively more and thus allows the dominant player to gain, say, 10% points of market share through the Covid-19 crisis such that its profits for the next 19 years will be $5.50 per annum. Now, as per our simple DCF model, the widget manufacturer’s fair value is 19 x 5.50 = $104.50. This simple model allows us to understand why across the world well-managed, dominant franchises have seen their stock prices soar even as the real economy has struggled through Covid.


Over the past century there have been three exigencies comparable to Covid-19 in scale and severity – the Spanish Flu which followed World War I, World War II and the GFC. The US stock market (the Dow Jones) rallied strongly after each of these crises had abated.  Specifically, the Dow rose 16% per annum through the 1920s. It rose 9% per annum during the period America fought in World War II (1941-45), and 5% per annum in the five years following the end of the war (1945-50). It rose 15% per annum for the first 5 years following the GFC and 12% per annum in the 10 years post the GFC. Both in the financial markets and in the real economy, the past belonged and the future belongs to those who are willing to assess risks rationally rather than emotionally.

Mark Mobius: Founder, Mobius Capital Partners LLP. Saurabh Mukherjea, Marcellus Investment Managers. The authors thank Nandita Rajhansa at Marcellus Investment Managers for her help with this piece.


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