Do you find it puzzling when a bleak economic report emerges from the press, only to be accompanied by a positive surge in the stock market? Or good news is reported and stocks sell-off?
If you said yes, you’re certainly not alone. The Coronavirus pandemic has produced many examples of a stark contrast between the economy and stock markets.
Take Ohio, for example. The governor shut down K-12 schools on March 12th and businesses a few days later. On March 22nd, a Stay-At-Home Order was issued. Though many had modified their social and spending behaviors in advance of the order, the economic shutdown was now in full effect in Ohio.
While adverse economic effects were just starting to increase in severity, the stock market, however, bottomed on March 23rd. Since then, markets have continued to rebound while economic reports continued to worsen in Ohio and nationally.
Why the apparent disconnect between the economy and markets?
After peeling back the onion, you will find there is not necessarily a disconnect. Instead, markets are forward-looking with current prices reflecting aggregate expectations of the future. Those expectations include expected economic developments that may impact growth, profitability, or other key variables that matter to investors.
For example, suppose expectations are the economic environment will weaken company cash flows. Stock markets may decline well in advance of when the weakening occurs. This was observable in mid-February as stocks began to sell off, but corporations hadn’t yet felt commensurate financial pain.
If the actual varies from the expected, prices will adjust. If things aren’t as bad as expected, poor economic news can be greeted with a positive stock reaction.
Take the June 6th unemployment report. It was reported to be 13.3%, making it one of the worst in history. However, expectations were for it to be even higher. Stocks were up sharply for the day.
Said another way, you can go from very bad to bad and still make money. Conversely, you can go from very good to good and lose money.
GDP & Stock Returns
Much has been written recently about the harm to U.S. gross domestic product (GDP), resulting from the Coronavirus and economic shutdown.
We can see the anticipatory nature of markets in action by looking at GDP growth and equity premiums. For reference, GDP is the total market value of finished goods and services produced within the U.S over a specific period, generally measured quarterly or annually. The equity premium is the return of stocks received over the return on cash, typically measured by one-month U.S. Treasury bills.
When annual U.S. equity premiums are analyzed against GDP growth for the same year, there is no discernable relationship between the two. Thus, changes in GDP have not been related to simultaneous stock market returns.
Some may rightly argue that GDP encompasses several measures of the economy, not just corporate profits. Yet, while GDP growth may be an imperfect proxy for stock market growth, further analysis shows that a pattern does exist.
If we instead analyze current-year GDP growth against the prior year’s equity premium, a noticeable relationship now emerges. The data suggests market prices have reacted to changes in GDP but have done so in advance of these economic developments coming to fruition. This result is consistent with markets pricing in the expectation of economic growth.
Markets At Work
The Coronavirus has provided investors a reminder that the economy and markets are not the same. Most importantly, it is a reminder that you should not rely on your emotions or economic reports but on a prudent investment process, grounded in science, to guide your investment decisionmaking.
“In every field of human endeavor, this reflexive/reflective split cleaves the world into amateurs and professionals, the former driven by their emotions, the latter by calculation and logic.” Dr. William J. Bernstein, Neurologist and Financial Writer.
Dimensional Fund Advisors, “Under the Macroscope” May 2020.