When the economy is roaring, we take it as a given that the stock market must be rallying too. Low unemployment, high GDP numbers, and robust wage growth all bode well for a soaring stock market. And while there certainly is correlation, the correlation can break down when reality doesn’t meet expectations.
How would we define a strong economy? Some of the most basic measures to gauge the health of an economy are full employment, target inflation levels, and real GDP growth of 3% or more. Most economists would agree that an economy that meets these criteria is at the very least healthy, if not strong. Even with this type of economy it is still possible for the stock market to go sideways or even down.
An efficient market should accurately price in expected future events. When there is a discrepancy in what investors price in and what actually happens, we see volatility in the market. For example, the market could drive up valuations because they expect 3% GDP growth. When the actual number prints at 2%, the state of the economy is still by all means healthy, but growth is slower than what investors had previously priced in. The economy can be objectively healthy while still missing the expectations that investors had based their decisions off of, driving the market lower.
The majority of past recessions have been led by bear markets. This would seem like a foolproof way to forecast a recession; just pay attention to what the stock market is doing. The problem is that while most recessions are led by a bear market, not every bear market indicates a coming recession. There can be instances of bear markets with little adverse effect on the underlying economy.
While not a foolproof indicator, maintaining this understanding lends itself to insight. By all current measures, our economy is strong. 4% unemployment, inflation on target at nearly two percent, and second quarter GDP growth reported at 4.1%. However, the GDP number at least appears to have been skewed by some one-time factors, so watching another quarter to see if it’s a trend will be important. If expectations do indeed grow for the strength of the economy, it is not a foregone conclusion that the stock market will follow in stride.
A great example was a conversation I had last week with an executive at a public company who was frustrated because their company stock was down 20% year-to-date despite meeting every revenue and earnings expectation. I conveyed that the stock was priced for near perfection and that’s why the stock was declining and “disconnected” from the company’s fundamental economic performance.
Just like many of the indicators that we have talked about in previous posts, there is no singular metric that can be used to forecast the direction of the market. While the economy is the backbone for a healthy investment environment, it is not the only thing to look at. Divergences can occur between the two and it is up to the savvy investor to properly weigh and consider all the information at their disposal.
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