There is generally much confusion about why the market and economy diverge during certain times, such as the current COVID-19 recession we are experiencing. Why are the stock markets going up when the economy looks like it is trending lower?

Typically, people have the Wall Street-Main Street/the real economy dichotomy in mind. Should they not align? The answer is straightforward: the stock market is not the economy; the economy is not the stock market.

However, they are related. The stock market is a leading indicator of what investors expect the economy is going to do in the future. Put another way: the stock market is forward-looking whereby everyone’s expectations are priced in. In contrast, the economy is backwards-looking in that it tells what has already occurred well after the fact.

Is it possible to track the real economy from the stock market?

There might not be a need. Josh Brown from Ritholtz Wealth Management used a brilliant analogy during an interview with CNBC to help visualise this: picture a person walking their dog in a park. The person is the economy; the dog is the stock market. The person and dog will be walking from one end of the park (point A) to the other (point B). The person would be walking in a clear path while the dog will be moving erratically for whatever reason (perhaps it wanted to interact with another dog or chase a squirrel), its movements will appear unstructured and unstable (sound familiar?). But ultimately, the economy and stock market end up at the same point.

Naturally, I had to bring in Warren Buffet who once said: “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”.

Buffet is right, and the way the equity markets performed during the global financial crisis illustrates his point. On October 2007, the market declined, two months before the start of the recession by the National Bureau of Economic Research’s (NBER) definition.

For reference, NEBR’s report states that the recession started in December 2009 and ended in June 2009. They don’t have a crystal ball nor did they have a top-notch mathematical model which called the recession ages ago. NBER didn’t announce these dates until September 2008; 1 year after the recession started, and December 2010 1 year after it ended. The business cycle dating committee determines these dates. Remember, economic data tells about information well after it has occurred!

Robert Prechter, (the gent who popularised Elliott Wave Theory) explained it beautifully in his book “The Socionomic Theory Of Finance”: that “aggregate investor thought is not conscious reason but unconscious impulsion”; “human herding behaviour results from impulsive mental activity in individuals responding to signals from the behaviour of others”; “The interaction of many minds in a collective setting produces super-organic behaviour that is patterned according to the survival-related functions of the primitive portions of the brain”.

Put another way; the market collective is greater than the sum of its parts, the individual market participants. Its perception is more significant because it encapsulates everyone’s expectations, so it is continuously ready to shift depending on the collective sentiment.

George Soros expressed it best when he said: “reflexivity sets up a feedback loop between market valuations and the so-called fundamentals which are being valued.” So as securities (equities, fixed income and FX) are being values, their fundamentals get affected, which changes traders/investors opinions about their prices which creates an endless cycle. It is like the Lucas Critique for the financial markets. Perceptions of what their prices should be. A process that plays out in a never-ending loop!

In hindsight, this would be an excellent time to own stocks. Would you say that during the time? That’s a different story. Equities bottomed out around 2009 then strongly rebounded; economic data at the time was worsening. Stocks were aggressively recovering; the bad news was not as bad as the markets expected.

The economy had been recovering. Although economic data was bad, it was better relative to the market’s expectations. The stock market trended higher aggressively; in contrast, the economy was doing the same at a “controlled” rate. Remember the analogy with the dog and the man walking in the park from point A to B!

That is why arguably why Buffet said what he said. You cannot assume terrible news in the economy will beget bad stock returns. In fact, academics have studied the relationship between stock performances and the economy which only further validate Buffet’s opinion.

Eugene Fama and Ken French suggested that there is strong empirical evidence that inverted yield curves tend to forecast economic activity. In their study, Fama and French built an active market timing model that shifts out of stocks based on yield curve inversions and concluded that was no evidence that yield curve inversions help investors avoid poor stock returns. They went on to state that the simplest interpretation of the negative active premiums they observed is that yield curves do not forecast the equity premium.

In other words, the ability to forecast economic activity does not lead to the ability to make profitable stock market timing decisions.

Another venue in the stock market-economy tie in the fallacy that your average joe may fall for is intuitively thinking that that stock markets in countries with high GDPs are always primed to generate superior returns. Alas, that is not the case. Jay Ritter unearthed this when he investigated the relationship between GDP growth and stock returns; he hypothesised that economic growth does not benefit stockholders. His results showed a negative correlation between stock returns and real GDP growth per capita in developed markets and emerging markets (including Russia, Brazil, China, and India).

In an efficient market, investors’ expectations are priced in. Thus, it would make sense that paying a high price in stock returns would only yield high stock returns if realised growth ends up being higher than expected. Put another way; there will be no boost in returns if growth is in line with expectations. The negative correlation in Ritter’s study would imply that investors overpaid for expected growth resulting disappointing investment returns; their expectations were too high. Researchers at the London Business School, Dimson, Marsh, and Staunton also found a negative correlation between national per capita GDP growth and stock performances.

To bridge academia to practice, then you could arguably, these studies provide us the insight to better understand the reasons behind the low returns in Chinese equities, despite the tremendous growth of the Chinese economy. Further cementing the idea that the economy is not the stock market; investors will not necessarily benefit from having equities in a country that has an excellent economy.

Why Investors' Decisions Should Not Be Influenced by The Economy?

An interesting and not-so-obvious reason why investors should be cautious about letting the economy influence their investment decisions is because structural reasons as Arnott and Bernstein’s research shows. They investigated the inverse relationship between the stock market and economy with what they dubbed “slippage effect”, the shortfall between economic growth and the growth in earnings per share. (Not to confuse it with slippage in the trading/investing context.)

They established that GDP and aggregate corporate earnings have been positively related from 1929. Though, increases corporate earnings does not benefit investors increases earnings per share (EPS) does! EPS can only keep up with GDP if no new shares are issued.

This is slippage comes in. For instance, picture in a rapidly growing economy where you own shares in one company Cap, and another one, Mac, enters the stock exchange, you will not benefit from the new company’s economic impact. Why? Because you will have to reallocate some of your capital to benefit from its new earnings, though doing do will not increase the value of your portfolio. The economy will be growing, yet your portfolio will not grow.

China’s the only economy I can recall that grew quickly, so that makes them a great example. Chinese equities experienced a lot of the growth in their market value, but this is because of the increase in the number of listed companies not price appreciation from existing listed companies. With the slippage effect in mind, we can understand the relatively poor stock returns in the Chinese equity despite their massive growth in their market capitalisation.

Arnott and Bernstein used the example of war-torn and non-war-torn countries from 1900 through 2000; they found that war-torn countries caught up with and surpassed the GDP of non-war-torn countries within a little more than a generation. The catch? The war-torn countries’ stock market growth trailed their economic growth by nearly twice as much as the non-war-torn countries’. Iin other words, higher slippage. They explained that war-torn countries had to go through a high rate of equity recapitalisation; new companies needed to form, and existing companies needed to raise new capital.

This is great for the economy, but this will not translate to returns for stockholders. Short- and long-term economic growth does not directly translate to stock market returns.

So next time someone tells you “invest in X company, it’s in Y country which is growing rapidly”, now you know better to carry stick to doing your due diligence.

Should Investors and Traders Ignore The Economy?

That is not to say traders and investors should completely ignore the two. Remember, I said they are not the same, but they are related. Right now (at the time of writing), the Fed is keeping the market going through accommodative monetary policy. Typically good companies would be rewarded, and bad companies fade away… but with the Fed’s printing we have a record of zombie companies (companies who can pay off the interest on their loans, but not the principal), so there is this build-up of rotting companies (akin to zombies) that appears to be building up until we reach a bust in the boom-bust cycle.

Hence why the stock market and economy eventually they lead to the same point in the end. At one point, one must give. The economy meets the expectations, or the market decides its expectations are too high and crashes. Considering COVID-19 has created a scenario that we have never had before (at the time of writing) It seems probable that a massive correction might be plausible.

As far as equity investors as concerned, many would make a strong case to say that the economy should not inform investment decisions. Some may disagree and present the view that the economy is the platform in which stocks are based in; however, it is possible to argue that (except acts of God, as per Dow Theory,) everything has been priced in.

Therefore, there is no need to include economic analysis into the stock investing process specifically. Especially as empirical evidence with the real-life application does indicate, it does not add value and investors are better off doing their own due diligence. However, it is worth monitoring the divergence between the market and economy as they do eventually end up at the same destination. Still, there’s no guarantee which one “leads” the other based on the nature of “market expectations”.

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