I received a great question from one of my clients, asking “Why doesn’t the stock market reflect our country’s economy?” That’s a question many people have, because they see the media hyping the stock market (it’s more fun to watch the market bounce up and down) and not so much our economy. They also hear politicians take credit for the ever-increasing stock market as being a result of their economic policies. (It’s not so!)
Ever since U.S. stocks began rebounding from their depths of late March, there has been a glaring, and many would say disturbing, disconnect between the devastating impact of Covid-19 on the economy and the celebratory mood of the stock market. Ten months later, that disconnect is as deep as ever. The virus continues to plague the economy and the well-being of millions of Americans while the market marches higher.
And the truth is, there’s nothing unusual about it. The market and the economy have rarely moved in tandem, and for good reason: The market is not the economy. Its job is to tabulate investors’ consensus view about the future of publicly traded companies. It pays no attention to private businesses or government or other important parts of the economy.
Let’s start with a definition of what or how our economy is measured. We use the GDP, Gross Domestic Product, to define how our economy is performing. “Gross domestic product (GDP) is the total monetary or market value of all the finished goods and services produced within a country’s borders in a specific time period. As a broad measure of overall domestic production, it functions as a comprehensive scorecard of a given country’s economic health.” (Investopedia definition) GDP growth rate is an important indicator of the economic performance of a country.
You may ask, “how is the GDP calculated?” (only if you really like to get into the details.) The GDP calculation accounts for spending on both exports and imports. Thus, a country’s GDP is the total of consumer spending (C) plus business investment (I) and government spending (G), plus net exports, which is total exports minus total imports (X – M).
Now let’s look at the stock market. Here’s the technical definition per Investopedia: “The stock market refers to the collection of markets and exchanges where regular activities of buying, selling, and issuance of shares of publicly-held companies take place. Such financial activities are conducted through institutionalized formal exchanges or over-the-counter (OTC) marketplaces which operate under a defined set of regulations. There can be multiple stock trading venues in a country or a region which allow transactions in stocks and other forms of securities.”
Stocks, also known as equities, represent fractional ownership in a public company, and the stock market is a place where investors can buy and sell ownership of these investable assets. An efficiently functioning stock market is considered critical to economic development, as it gives companies the ability to quickly access capital from the public.
Note, there is no mention of how much consumers or governments spend, the stock market is solely the stock value of publicly-held companies. When you compare the definition of the GDP to the Stock Market, you see they are different. GDP is more comprehensive where the stock market only includes the value of publicly traded companies. As a matter of fact, the stock market often obscures what’s happening in the broader economy.
The years since the 2008 financial crisis are just the latest example. The stock market has performed far better than usual since the crisis, mostly because corporate America has enjoyed huge profits. Meanwhile, the economy has struggled to grow, leaving lots of Americans behind and widening the gap between rich and poor. Covid-19 has further deepened that divide. If you looked only at the market, you would hardly know anything was amiss.
We also need to keep in mind that the stock market looks ahead six or even twelve months, and I think the year-end rally was pricing-in a strong recovery in the second half of 2021.
So what can be done to clear up the confusion around the market and the economy? Media outlets, for one, can make economic data as visible as stock tickers, granting that watching stocks bounce around is far more exciting. Economists and financial pundits can be more careful about using the market as a proxy for the economy, and push back when politicians do it. But perhaps the best way is to just say it plainly: The stock market doesn’t care about the economy.
According to Zack’s Investment, “there is a lot to look forward to in 2021, and investors should position portfolios towards equities – but only as far as your risk tolerance and long-term objectives allow. It is also, of course, important to remain diversified.”
They believe that investor optimism may be moving a bit too quickly, however, and the risk-taking they are seeing is likely to give way to more frequent volatility and likely a correction that will feel like another bear market (sharp, sudden, scary). Staying patient, focused on the long-term, and biased towards quality and earnings should serve investors well in the new year.
The bottom line is we need to separate our emotions about the political state of the country from our investment decision-making process.
When you are ready to learn more about investing, schedule your free 20 minute Discovery call with me.