The title is a shorthand way of saying that the most recent performance of the economy isn’t predictive of the future performance of the stock market. The bottom line is that GDP growth today doesn’t necessarily mean stock price growth today – GDP growth and stock returns are not highly correlated. In fact, some analysis suggests that they are negatively correlated and perhaps fairly strongly so (-0.40). Why the negative correlation? If one believes that markets anticipate, then high GDP today would have been anticipated in advance and incorporated into the current price of stocks. Nothing controversial about that observation.
Today’s stock prices reflect a view of the economy some distance in the future. How long? Well, I think that depends on what investors are looking forward to, what they expect to affect the economy. Investors may be looking forward to a future event they expect to have an outsized impact on the economy, like say an election or a big change in economic policy. As expectations change about the outcome of the election or the policy change becomes more or less likely, the market will fluctuate as the new information is absorbed into and reflected in the price. There may be other, less significant events that also attract investors’ attention but there are generally only a few things – sometimes really only one – upon which most investors are focused.
Today’s stock price has less to do with the change in GDP that already happened but rather more what the change in GDP will be in the future. The fact that GDP has grown recently tells us nothing about what to expect from stocks or bonds or any other asset – or does it? The fact that the two are negatively correlated does tell us one thing – economies are cyclical. Periods of strong growth are inevitably followed by periods that are weak and vice versa. And stock prices, reacting quickly and providing a real time, crowd sourced estimate of future growth – a real time test of the wisdom of crowds – tend to lead the economic cycle. So, stocks decline before the drop in GDP growth and rise before its improvement. Again, nothing heretical in that observation.
The question then becomes one of why economies – and therefore stocks – are cyclical. Of course, that is a debate that has been going on now for a long time, usually fleshed out as a debate over the ability of monetary or fiscal policy to affect that cyclicality. Can the Fed manipulate interest rates – or its balance sheet – such that the business cycle can be tamed, the amplitude of the wave suppressed? Are there costs to doing so or is this the only free lunch in economics? If you’ve been reading along for a while, you won’t be surprised to learn that I think there are indeed costs and that we don’t know the final tab for the Great Moderation yet because we’re still using the same policies that produced it, even if that stab at central planning has failed pretty miserably.
The causes of the cyclicality aren’t all that important anyway for the long term investor. For the long term investor the very existence of the cyclicality is sufficient to accomplish his/her goals. Merely knowing that the correlation between GDP growth and stock returns is negative should be sufficient by itself to perform acceptably over the long haul. Merely reduce one’s exposure to stocks following periods of stronger growth and raise it after periods of weaker growth or contraction. The better you get the timing of that, the better your performance will be relative to a passive allocation investor. Just don’t take that approach to an extreme. Don’t sell all your stocks or bonds.
So with that as background, it was interesting last week to watch the US stock market react to the events of the week. Stocks spent most of the week trending higher on the back of an improvement in retail sales (which really wasn’t that great but still better than expected), some employment market improvements (JOLTS, jobless claims) and a bump up in sentiment (small business and individuals). Bonds, meanwhile, were pulling back as the better data potentially moved up the date for a Fed rate hike. In other words, expectations about future growth affected current prices, the market assimilated new information. Two events worked against stocks earlier in the week though so the gain was positive but minimal. The two events? First was a report that President Obama said in private talks at the G-7 summit that the strong dollar had been a “problem”. The second was the IMF walking out of the Greek debt talks. Neither of those events were sufficiently negative from current levels to push stocks lower though.
Friday the market gave back almost all those gains though as Congress refused to grant President Obama fast track authority to negotiate the TPP (not directly but the likelihood of passage of the trade pact is pretty low and getting lower if not to nil yet). Whatever your feelings about the trade deal, the message sent last week about the country’s position on trade was pretty clear. In fact, the message on trade from around the world the last few years has been pretty clear. Currency wars or competitive devaluations or whatever you want to call them are only part of the current rising antipathy toward trading with our neighbors. In addition, the US Presidential election cycle is getting started with a clear populist tilt that has one side blaming globalization for our economic problems and the other immigration. It is not a friendly environment for free traders and the market isn’t going to like that because ultimately limiting trade and immigration will hurt the economy not help.
Of course, we probably shouldn’t read too much into one week’s action and the fact that stocks were flat in a week of pretty good economic data may not mean a thing. But if we want to try to get ahead of the crowd in recognizing a turning point in the economy, we should look a bit deeper. Again, maybe just coincidence, but high yield bonds were down last week while Treasuries, by the end of the week, were higher. TIPS yields, a market based indicator of real growth expectations, were also lower on the week. The dollar was also down and gold higher, a trend that is still developing but now three months old. Gold has in fact outperformed the S&P 500 over the last three months. None of those things are consistent with rising US growth expectations.
Meanwhile, foreign stocks had a pretty good week, extending a trend that started at the beginning of the year. All the talk the last year or so has been about the US economy leading, growing faster than the rest of the world. Well, true, but as I pointed out in the opening paragraph that is more likely a negative signal for US stocks and a positive one for foreign ones. It is almost inevitable that US growth will slow and foreign growth will pick up, at least relatively. The US may not be headed for recession – the jury is still out on that one for now – but future growth expectations appear to have peaked about 5 months ago when stocks did the same.
One can’t invest looking at current economic data alone. How the US approaches economic policy affects future growth and that will get reflected in stock prices. President Obama’s plaint about the dollar (denied but I think it is fairly safe to say he really said it) and Congress’ attitude toward trade are not positive for stocks because they aren’t positive for future growth. And that will trump a backward looking retail sales report any day of the week. The stock market and the economy are both cyclical but it is a mistake to think they are in sync. So, one more time: the economy is not the market.
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