What Is The Relationship Between The Economy And The Stock Market?

Does The Economy Predict The Direction Of The Stock Market?

Predict The Direction Of The Stock MarketSo often we try pour through economic data in an attempt to ascertain which direction the stock market might be headed in the near future.  However, the ups and downs are somewhat eluding as the market seems to do its own thing in spite of the economy.  In a July newsletter, BNY Mellon Asset Management made the statement 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.  Other individuals who have driven that point home are Peter Lynch, who said : “If you spend 13 minutes a year trying to predict the economy, you have wasted 10 minutes.”   And Nobel Prize winning economist Paul Samuelson who stated:  “The stock market has called nine out of the last five recessions.”   In their opinion, market projection cannot be done accurately by pouring over unemployment, GDP and other economic indicators.

Focus  On Valuation On Economic Indicators To Predict The Direction Of The Stock Market

Basically, the data points to the fact that the correlation between the change of the 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 have been equally small.  Thus, does it pay to get all up in arms and frantic about a small change in the economy?  The latest in a large body of studies concerning the relationship between economic growth and the stock market was done by Vanguard.  They examined the predictive power of important economic variables.  After the completion of their study the concluded that:  “None of these factors come remotely close to forecasting accurately how stocks will perform in the coming year.”  Their final conclusion is that if you hope to have a hope in accurately predicting the direction of the stock market, only P/E ratios (valuation) had the ability to predict the direction of a specific stock or market.

What Do The Great Investors Use To Predict The Direction Of The Stock Market?

The truly 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 the stock market and on whether or not now is a good time to jump all in or pull back, speak to a Redhawk advisor near you today.


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