The stock market and economy are two very different animals

I think one of the hardest things for novice investors to grasp is the idea that the economy and stock market are two very different animals. In fact I start a chapter on Equities in my book Abnormal Returns: Winning Strategies from the Frontlines of the Investment Blogosphere with the title: “The Stock Market is Not the Economy.” There is ample data to show that a negative relationship exists between economic growth and equity market returns. What this relationship omits is valuation. Starting valuations have a big role in future returns, not economic growth.

This theme about the perceived disconnect between the stock market and economy has been touched on by a number of writers this past week.* Josh Brown at The Reformed Broker post-debate on the link between the two had this to say:

It’s a difficult concept to grasp when you’re trained to look for narratives and storylines as most journalists are. Steve is a very good economic reporter and brings a wealth of information to the viewers each time he’s on. I was simply trying to make the point that the Greek stock market had risen by 30% last year despite a contracting economy while in Shanghai stocks were down all year as the Chinese economy grew by 7%. Thus, the Economy ≠ the Stock Market.

Barry Ritholtz writing at the Washington Post has an article arguing not only does economic have a limited role in investor decision making but so do political machinations as well. Barry also notes the importance of valuation on decision making as well.

Most folks seem surprised when I tell them the sequester will have “little or no” impact on markets. The correlation between how markets perform relative to economic events is actually quite weak…Indeed, the correlation between economic noise and how equity markets perform has been wildly overemphasized. To quote Warren Buffett: “If you knew what was going to happen in the economy, you still wouldn’t necessarily know what was going to happen in the stock market.”

Peter Coy at Businessweek does not one feedback mechanism between the stock market and the economy. One that the Fed is hoping will happen sooner rather than later.

The stock market’s importance is more symbolic than economic. Only a handful of companies use it to raise money in a typical year, and most families have more wealth in real estate than in stocks. What higher stock prices do is signal to CEOs that investors want them to put their money to work. Farmer argues that rising stock prices may yet rouse dormant animal spirits and get the economy going again. If that’s so, then the Fed’s strategy will have worked.

Although not directly related to the earlier discussion I thought this piece by François Sicart at AlphaNow was interesting in that it delineates the differences between the goals of the entrepreneur and the stock market investor. They have very different outlooks and one shouldn’t approach stock market investing with the same attitude entrepreneurs bring to the table.

The primary goal of an entrepreneur is to create a fortune, in part by taking significant risk when necessary and when the potential return warrants it. The goal of an investment manager is to protect a patrimony against (or through) economic, political, or financial crises – as well as against the loss of purchasing power due to inflation. With the right discipline, this patrimony should also grow over time.

But the successful entrepreneur and the successful investment manager have different skill sets and instincts. Good judgment demands that one should not attempt to practice in the other’s field of excellence.

We want to believe the stock market and economy are inextricably linked. That is what the financial news industry is built upon. The economic indicator announcement is a staple of business TV. Maybe that is yet another good reason to go on a “news diet.”

*Although one could argue like Joe Weisenthal at Money Game does that the stock market has been moving in lockstep with initial weekly unemployment claims over the past six years.

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  • Tadas ViskantaAbnormal Returns has over its seven-year life become a fixture in the financial blogosphere. Over thousands of posts we have striven to bring the best of the financial blogosphere to readers. In that time the idea of a “forecast-free investment blog” remains as useful as it did six years ago. More »

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