Is the Market Unhinged from the Economy?

"The stock market is rocketing higher while the economy is in shambles. I expect the market to reflect the underlying economy very soon." - Everyone

The real economy has been devastated by the fallout from COVID-19. Record spikes in unemployment, businesses shuttering, and government dropping money out of the sky. On the other hand, after a rapid 30% drop in March, the U.S. equity market is essentially back to where it started the year. The general consensus is the stock market is way ahead of itself.

The perception is the gap between Main Street and Wall Street is wider than ever. We attempt to provide some context to a seemingly baffling development. In other words, should the stock market reflect what's going on in the real economy?

It's complicated.

Gross Domestic Product (GDP) is the sum of all goods and services produced in a specific time period (usually measured quarterly and annually). Without getting too deep in the weeds, personal consumption, investment, government spending, and exports are components when calculating GDP. We'll use GDP as our "economy" proxy.

The S&P 500 will be our "market" proxy.

This is a subject of great controversy and debate. Intuitively, it makes sense economic growth or lack thereof should affect company earnings, which should influence stock prices. This linear thinking path makes sense, but the relationship doesn't always hold up.

Here's a note from Northern Trust about the relationship between economic growth and stock market returns.

Dimson, Marsh and Staunton (DMS) studied the relationship between long term stock market returns and long-term GDP growth. Their sample included a cross-section of 21 countries with equity return and GDP growth data from 1900 to 2013. Fifteen of the 21 countries were in Europe, so the sample largely represented a similar economic history.

The DMS researchers found a modest negative correlation between real (inflation-adjusted) equity returns and per capita GDP growth, and they found a modest positive correlation between real equity returns and aggregate GDP growth. The results were mixed and the evidence linking equity returns to GDP growth was weak, surprising many investors and economists.

The weak link between GDP growth and market returns might be surprising, but we don't need to look very far to find examples.

Source: Bespoke Investment Group

The above chart shows cumulative real GDP growth from 2000-2009 (blue) and the S&P 500 (orange). The real economy grew at a slow & steady clip while the US equity market floundered.

The opposite was true from 2010 to today...

Source: Bespoke Investment Group

The above chart shows cumulative real GDP growth from 2000-2009 (blue) and the S&P 500 (orange). The real economy grew at essentially the same rate as the previous decade (2000-2009), but the market had a completely different reaction.

Borrowing a graphic from last week's post, the link between GDP growth and equity market returns seems fleeting globally as well...

The above graphic shows annualized GDP growth (last column on right) for Indonesia, India, Vietnam well over 6% per year, while the annualized equity returns were negative for every country except India.

It would seem a decoupling of economic growth and equity markets are not uncommon. Furthermore, the link appears to be weak following more randomness than significance.

A few observations on what's currently going on...

The Fed has mucked up the traditional business cycle. What was true 30 years ago has been distorted by the unprecedented monetary policy experiment. Using the old playbook to connect the dots might lead to incorrect conclusions.

The economy can be described as what's happening now. Economic data that rolls in is what happened yesterday. The market is forward looking i.e. what's going to happen next quarter, next year, the next few years? It's been said the stock market is the world's best and most accurate forecaster.

Stock market performance can influence sentiment and consumer confidence. Former Fed Chairman Ben Bernanke dubbed this the "wealth effect." The thinking around this is that as the market goes higher, consumers feel more confident and are more likely to spend money, thus bolstering the real economy. The opposite is also true, the market goes down, people feel worse, and are inclined to save more.

Finally, the market doesn't have to do anything rational. Just because everyone thinks the market is well ahead of itself doesn't make it so.