Why economic growth does not drive the stock market

Fri 04 Dec 2020

By Brian Dennehy

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Over the last week it has been fascinating to read comments across the media and from an array of the best brains in investment banking. What changed in recent weeks? Will it last? Some Gold Members have asked similar questions.

lookEconomies and markets are extremely complex, some say chaotic in the case of markets. But investors thirst for simple answers, and this is fed by the investment industry, from the great global investment banks and down, and then channelled through an array of media outlets.

An article by Robin Wigglesworth in the FT this week illustrates the point. [Not having a pop at Robin – I invariably enjoy his articles]

Mostly it focusses on the views of US-centric investment banks, Goldman Sachs etc, regarding the US economy, and its feed through to the US stock market.  The underlying premise is that a strong economic recovery next year will support the US stock market – the assumption is that the economy drives the stock market.

It doesn’t.  It is confidence which is the driver of both the economy and the stock market.

In another blog this week (Does Inflation drive the stock market?) I look at how economic factors have little practical value in figuring the stock market.  Specifically, in 19 Bad Habits, no.13 is “Stop confusing economic growth with stock market potential”:

“Most people believe, and it is natural to do so, that an economy which is obviously growing, and growing more than elsewhere, is a place where you should invest your money.  Yet volumes of research inform us that it is wrong to do so.

The Credit Suisse Investment Returns Yearbook 2014 went into great detail, crunching data from 1900 across 21 countries.  The conclusion is simple:

Buying the equities of countries that have experienced the highest economic growth fails to give a superior return.”

In so far as confidence being the trigger for both the economy and the stock market, this will necessarily show up in the stock market today, but will not show up in economic statistics for some months. 

For example, I express my investing confidence by putting money into the stock market today, and this is instantly reflected in prices today.  On the other hand, on the same day, I express my business confidence by making a decision to buy new machinery, but that will not show up in economic statistics for months.

Overhanging investor confidence this year has been the investor dilemma which I have often mentioned.

Great value in significant parts of the UK stock market vs US investment mania.

In many blogs this year I have said this or similar:

“You need to balance keeping your guard up, while also remaining sufficiently positive to identify opportunities as they emerge – that balance is not easy.”

And also:

We often feel uncomfortable with change, but change is the natural state of things”

We prepared the ground for that change over months, persistently highlighting the opportunity in Value-style funds.  When evidence of the rotation into Value was clear we moved fast to act on this.  If history is s good guide, this change in fortunes can persist for years.

Yet the US mania remains a huge risk, and the vulnerability to a shock persists.  Despite the events of this year, the vulnerability of markets is not just unchanged but, on some measures, worse.  As has been the case for a couple of years, we have no idea of the nature or the timing of that shock.  But the arrival of coronavirus showed how a vulnerable market will adjust rapidly.

It feels bizarre to say it, but from an investors perspective the pandemic hit on the stock market is likely just a dry run – think of it as a learning experience.  In the weeks ahead you could do worse than write a few lines on what you think you learned from February 2020 onwards.

In conclusion:

  • Economic growth does not drive the stock market. 
  • The events of recent weeks have justified taking on more risk in areas where there are clear opportunities. 
  • Those opportunities can persist for a while yet. 
  • But because of the vulnerability to a shock, a stop-loss is vital.

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