August 07, 2020
Mark Minchin

The Correlation between the Economy and the Stock Market is Low in the Short-Term

Perhaps the most common misconceptions about the share market is that it is directly linked to a nation’s economy. This is simply not the case. History shows time and again that markets can perform well when the economy is slowing and vice versa.

In large part this is because share markets are ‘forward looking’. They are driven by company valuations and valuations are determined by market participants collective consensus view of the likely long-term earnings potential of companies.

Or put another way, the price you are prepared to pay for a company today is generally a function of the profits you expect the company to earn over the next ten years and beyond (not just the profits you expect the company to make in the next quarter, or the next year).

So, when you value a company today, you consider the likely earnings it will produce in each of the forward years. For example, right now you may assume a company’s profits to be soft for the next two or three years and then see in a recovery after that. Your net present value calculation will use your estimate of profit for each of the forward years, discounted by the current interest rate today.  Because you are valuing the company’s future profits for a whole decade or more, the impact on the valuation of one or two soft years (out of say ten or fifteen) may only be modest. 

Beware of Cognitive Dissonance

Notwithstanding this logic, the current environment is particularly challenging for investors because every day we are receiving bad news about the economy and yet we are also receiving news that stocks are rising. This disparity is difficult to process because our minds find it hard to entertain two opposing thoughts at once. Consequently, we are inclined to dismiss one or other to make the decision making process easier. Yet, this is rarely the right approach.  

One of the most ironic aspects of investing is that the greatest gains can lie ahead at times when things are bad, but not quite as bad as everyone suspects, and slowly, almost imperceptibly getting better. This is the moment when assets are selling at discounted prices. 

Conversely, the worst time to invest is once everyone agrees that the environment is great and that the gains will continue. It is at this moment investors can find themselves over paying for assets and competing with many other buyers who hold the common sentiment. 

Over the longer term we do see a correlation between stocks and the economy, but over shorter periods – say less than a year – there may be no rhyme or reason for what has happened.

Investors are not well served by trying to make investment decisions based on the economic outlook for the following reasons:

  1. The future is impossible to predict. 
  2. Even if you knew what would happen in the future, you would still have to guess about what might already be in the price. 
  3. There have been many years during which stock markets have rallied as the economy has performed poorly. There are also many years during which the economic data was strong, but stock prices were weak. No one can reliably predict which of these scenarios is more likely to occur. 

In turbulent times the most sensible approach for investors is to adhere to their long term investment program. Making changes during these times is fraught with danger and the odds of success are very low. 

Being a successful investor involves taking the good with the bad, accepting that the average of both will be a good return in the long run. Tempting as it may be to ‘time the market’, the evidence suggests that precious few ever time both the exit and the re-entry profitably. 

Read on.

Massive Government Stimulus has Reflated the Markets

Any rational assessment of current market prices needs to factor in the huge increase in the money supply that has been spawned by global governments’ ‘whatever-it-takes’ intervention to support markets, businesses, and workers.

August 07, 2020