This year’s headlines have delivered upbeat news about the economy – strong G.D.P. growth, low unemployment rates, and little sign of higher inflation. Concurrently, the U.S. stock market has climbed higher.
We have heard clients draw a straight line between the economy and stock market. The two are interconnected. Strong economic growth feeds into corporate earnings, thereby driving stocks higher. Conversely, in a recession, less economic activity hurts corporate earnings and therefore stock prices.
Yet, the relationship between the economy and stock market is not as strong as many expect. Economic data is backward-looking; it uses what has already happened to estimate where the economy is.
The market is forward-looking. Today’s economic data is already reflected in stock prices. Expectations and emotion (fear and greed) drive short-term stock prices far more than economic fundamentals.
For example, if Apple reports a record number of iPhones sold but the market expected that Apple would sell more, then unmet expectations would likely cause Apple’s stock price to drop. The record iPhones sales would reflect well on economic data but could have a negative effect on the stock market.
From 2009 to 2012, the economy was recovering from the Great Recession. Unemployment fluctuated between 7-10%, and GDP growth was unimpressive. Yet the S&P 500 was up 72%. Lowered expectations drove prices down, creating a great buying opportunity.
“If you knew what was going to happen in the economy, you still wouldn’t necessarily know what was going to happen in the stock market. ”
— Warren Buffett
The economy and stock market have a weak short-term relationship because price matters in the market. There is no asset so good it cannot be overpriced. There are few assets so bad they cannot be underpriced. A mansion can be a horrible investment at an inflated price while a rundown home can be a great investment at a depressed price. It’s not what you buy, it’s what you pay.
Moreover, economic data is fickle. Economists did not discover and verify the Great Recession until December 2008, a year after it started, or the March 2001 recession until November 2001.
There is an old joke that economists exist to make weathermen look good. Economic data informs us about forces that have shaped the stock market. Economic data is not a useful input for developing a forward-thinking investment strategy.
