How Strong Is The Correlation Between The Economy And The Stock Market?

Can You Make Predictions On The Stock Market Based On The Economy?

Stocks And EconomyIn a July 2012 client letter BNY Mellon Asset Management tells us that “as counterintuitive as it might seem, data suggest that high economic growth rates do not necessarily correlate with the highest long-term stock market returns.” This is hardly a new discovery but it’s important that we be reminded of it on a regular basis.  A great quote in the letter by Nobel Prize winning economist Paul Samuelson:  “The stock market has called nine of the last five recessions.”

The letter concludes, “Over longer time periods, statistical correlation between the quarterly change of real U.S. GDP and the S&P 500 is virtually zero. The correlations between the EuroStoxx 50 and the Eurozone GDP since 1999 and between the DAX and the German GDP since 1991 are similarly small.”

What Is The Relationship Between Economic Growth And The Stock Market?

The latest in a large body of studies concerning the relationship between economic growth and the stock market was done by Vanguard. They looked at the predictive power of important economic variables. Their conclusion: “none of these factors… come remotely close to forecasting accurately how stocks will perform in the coming year.” They went on to say that even over a 10-year time horizon, only P/E ratios (valuation!!) had a meaningful predictive quality.

Focus On Valuation Not Economic Data When Selecting Stocks

Is it any wonder why so many great investors of yesterday and today—Graham, Templeton, Lynch, Buffett, Cooperman—focus on valuation? They understand that the best time to buy stocks is when they are cheap on a valuation basis, regardless of what the economy is doing. This by no means suggests the economy is irrelevant. It only suggests that buying stocks on the basis of current economic performance is a poor strategy because they have absolutely no correlation.

Howard Marks of Oaktree funds noted that within a cycle, stock prices rise and fall much more than profits. Thus he has become convinced “that fluctuations in investor attitudes toward risk contribute more to major market movements than anything else.” So, are investor attitudes toward risk also the key determinant of P/E ratios? Stock market action over the last 20 years would say the answer is …yes.

For more information on making important financial decisions such as when to invest and when to pull back, speak to a Redhawk Advisor near you today.

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