The Economy is Not the Market
The Economy is Not the Market
July 12, 2023
Author: Jason Kirchhoff
Hard landing, soft landing, no landing? A lot of ink has been spilled in the financial press over the past few years discussing how the economy might (or might not) slow down and when the next recession will start. It is often assumed this information is important for investors because intuitively there should be a strong link between the economy and the stock market.
However, when looking at the data and academic research, the relationship is tenuous at best, especially over a shorter time horizon. A recent May 2022 joint research paper from UCLA and The University of Florida found GDP growth (a proxy for economic growth) to be “unreliable in predicting country-level stock returns”. Another good example of the unreliable relationship can be found by reviewing U.S. recessions going back to 1953: the S&P 500 was positive during 5 of the 11 recessions. This might sound surprising given the time and effort economists spend trying to predict GDP growth, unemployment changes and other various economic statistics.
Why isn’t there a closer relationship between the stock market and the economy?
- Forward-Looking Nature: The stock market is forward-looking, with current prices reflecting the collective expectations of all market participants. The Conference Board, a non-profit think-tank, publishes leading, coincident, and lagging indices designed to signal peaks and troughs in the business cycle and economic growth. Notably, the S&P 500 is part of the leading index, which aims to provide advanced warning about potential changes in the economy. Thus, predicting the economy using the stock market may yield better results than trying to predict the stock market from economic predictions.
- Incomplete Representation: Economic growth is driven by the development of new and smaller businesses, which may not be adequately reflected in indices dominated by large public companies like the S&P 500.
- Multiple Factors Impacting Earnings: Economic growth does not always directly translate to corporate earnings. Over shorter periods, the relationship between economic growth and earnings growth is weak. Earnings are influenced by factors such as interest rates, labor costs, tax changes, regulatory policies, and global revenue streams of corporations.
The current state of the economy can have an impact on our careers and standard of living, but it doesn’t necessarily carry meaningful information for how your portfolio should be allocated. The track record of experts’ ability to predict economic growth is weak and even if we knew the future path of the economy with 100% certainty, the investment implications are uncertain. Key takeaway: Don’t let the “noise” of economic prognostications distract you from your financial plan and long-term goals.
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