The Stock Market is Not the Economy

By Charlie Bilello

U.S. economic growth in the 1st quarter came in at 2.3%, right in line with the average level of the expansion that began in June 2009. As you can see in the chart below, this has been the slowest growth expansion in history.

Data Sources for all charts/tables herein: NBER, FRED, Bloomberg, NYU.EDU

Has that impeded stock market performance? Not at all. At 15.2% annualized since June 2009, stocks have fared quite well. Which begs the question, what exactly is the historical relationship between the stock market and the economy? Let’s take a look.

On a calendar-year basis since 1930, there’s a 0.26 correlation between the S&P 500’s total return and the change in real GDP.

On a year-over-year basis since 1948, the correlation moves up to 0.31.

So there’s a positive relationship between the stocks and the economy, but it’s not nearly as high as you might think. That leads to some counter-intuitive results at times.

For instance, a contraction in the economy during a given year does not necessarily mean a falling stock market. We saw that most recently in 2009 when real GDP declined 0.2% while stocks advanced 26.5%.

5 out of the last 10 U.S. recessions actually had positive stock returns during the full period of contraction.

While less common, the same is true in the opposite direction. Some of the best years for the economy have featured negative stock performance.

What gives? Why are stocks not moving precisely in tandem with the economy?

For one thing, stocks tend to be a leading indicator of the economy. That means in years like 2009 when growth was negative, stocks were looking ahead to better growth to come. It also means that in years like 2000, when growth was positive, stocks were looking ahead to weaker growth (recession began in March 2001).

Where this gets complicated is that stock returns are frequently not telling you anything important about the economy, but instead simply reflecting changing investor sentiment. At times investors will pay more for a given level of earnings and at other times they will pay less. What’s going on in the economy is just one factor in that determination.

Stocks are ultimately a reflection of what investors are willing to pay today for a stream of long-term corporate earnings, which is not nearly the same thing as changes in short-term economic growth. Hence, the stock market is not the economy. Understanding that as an investor is critical.

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Gary

NFTRH.com & Biiwii.com