Should I Pay Attention to the Stock Market or Economy?

March 11, 2020 Author: Tess Downing, MBA, CFP®, Complete View Financial

Complete View Financial

In times of market volatility, everyone is looking for an orientation of what to do. Buy? Sell? Or hold? And this is one of those times.

If you are working with a financial planner, you will likely have a long-term investment strategy. You will want to touch base and confirm, based on your specific circumstances and retirement window, if your plan should or shouldn’t change.

Investors who are working on their own may already have their narrative of the best predictors of market direction: whether it’s the stock market or the economy.

What is most concerning is when an investor is caught totally off guard and is looking to the ‘talking heads’ on online or TV financial programs, or both. Just one day of watching will contribute endless news bits about the economy and the market’s behavior at that moment.

Yet, as you go from host to host, the correlation is inconsistent between what’s happening in the real world and what you see the market indices doing.

So, let’s take a look at how the market and the economy interact, and where we might find the most reliable orientation.

Do I Follow the Dog or the Man?

One of the best-known analogies to explain the relationship between markets and the economy comes from Ralph Wagner, a fund manager and author. This is his take:

You see a man walking his dog across a park. He is walking with a regular stride, with minimal deviation. Think of his movement as an economic trend.

Now, let’s look at what the dog is doing. It’s sniffing the grass, then darting ahead, straining the leash. It swerves right and left, barks at a squirrel, then sits down until it feels the tug on the leash because its ‘walker’ is still moving forward.

The man is the economy, and the dog is the stock market. They both end up in the same place, and they’re walking in the same direction most of the time. But, there is far less deviation of the man’s path than the dog’s.

Wagner’s analogy is useful whenever you see the stock market fluctuating. Think of the market jumping around, barking and straining at its leash. It’s one way to quiet some of your apprehension, knowing the economy is not fluctuating as much as the market is.

But does the walk across the park represent a defined period, such as a year? Only if by coincidence. Instead, over long periods we see the correlation between stocks and the economy. But in shorter periods, there is not necessarily any correlation.

Times When the Market and the Economy Did or Didn’t Agree

Let’s look at a few familiar moments to see how the two elements interacted. For the market, we can use its indices. For the economy, a good measure is real GDP (which is the nation’s economic growth adjusted for inflation). As examples:

  • At the end of the 1973-1975 recession, the S&P 500 rose by nearly 40% in 1975, but real GDP fell by 0.2%.

  • During the Great Recession, by March 2009 the Dow had fallen to levels last seen in 1996. Yet, for the year, the Dow went up 18.82% while real GDP fell 2.5%.

Even if we could project future GDP, the stock market’s reaction would be impossible to predict.

But, are stocks better leading indicators? Can they tell us what the economy is going to do?

On October 19, 1987, Black Monday, the Dow dropped 22.61%, after five years of a bull market. It was triggered by some proposed changes in tax legislation and then magnified by computerized stock trading programs. The drop had nothing to do with the economy, and the economy hardly noticed. The year 1987 ended with the same real GDP growth as the prior year: 3.5%. And in 1988, it grew by 4.2%.

Yet, sometimes stocks do get the projection right, as they did in the Dot-Com crash of 2000. The U.S. had a banner economy from 1982 to 2000, when Wall Street said markets were getting way too hot. On April 14, 2000, all the major indices were down for the year. What started with technology stocks moved to Main Street stocks and led to a fairly long recession.

So, the main question is this: when there are changes in the market, are they signaling things to come or not? In real time, it’s virtually impossible to know.

So, What Factors Do Influence the Markets?

By now, we know we cannot count on stock-market forecasts that are based on today’s economy. Too many other factors can affect stock prices, such as a natural disaster, a presidential tweet, interest rates, tax rates, geopolitics or projected Fed actions.

Any of these non-GDP factors can move markets. But amidst such activity, no single economy-based metric – such as unemployment rates, jobless claims, the U.S. or global GDP – can be credited with raising or lowering markets.

If forecasting were that simple, we would all know how to invest. And we would all be rich.

And What Role Do Expectations Play?

Expectations can also affect stock market performance.

The Tax Cuts and Jobs Act (TCJA) was signed into law in late 2017, effective in January 2018. 2018 brought substantial GDP growth (2.9%), millions of new jobs (2.9 million) and a steadily dropping unemployment rate among all groupings of people. Everything appeared positive with the economy.

With that positive context, who would have imagined that almost all assets would suffer annual declines by year-end? However, the Dow fell by 5.6%, the S&P 500 by 6.2% and the Nasdaq Composite by 3.9%.

So, what happened? Expectations. People were already worried about 2019, and that pulled the markets down.

What About the Federal Reserve’s Role?

Stock market watchers keep an eye on the Federal Reserve, waiting with bated breath for the notes coming out of the Fed’s periodic meetings. The expectation is that the Fed will be watching markets and reacting to what it sees. In terms of our ‘walking-the-dog’ story, that would mean its chairman, Jerome Powell, would be a dog watcher. In fact, with rare exceptions, he watches the man.

So, How Do I Play a Whipsawing Stock Market?

Since late February, we have seen the major stock indices rise and fall by never-seen percentages. You may be asking, “How should I respond, if at all?” And, “How should I make those decisions?”

Your decisions are very personal. Among other things, they depend on your circumstances, your time-to-retirement and your confidence in your existing strategy.

One thing is sure: the volatile market pricing is ignoring economic reality. Instead, it is reacting to countless external factors, uncertainty and emotional expectations.

It is ignoring the man and focusing on the hyperactive dog.

If you believe you could benefit from visiting or revisiting your financial strategy, feel free to call Complete View Financial for an initial consultation.