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Why The Stock Market is Different From the Economy

Every day, thousands of Americans tune into their favorite business news channel and hear about how fluctuations in the economy directly affect movements in the stock market. Many viewers will then make decisions based upon current or anticipated economic events. And many of those decisions will turn out to be costly. Both history and research show that the stock market and the economy are two very different entities.

In January of 2009, during the peak of the worst economic crisis Americans had experienced since the Great Depression, President Obama stated: “We start 2009 in the midst of a crisis unlike any we have seen in our lifetime, a crisis that has only deepened over the last few weeks. Nearly 2 million jobs have been now lost, and on Friday we’re likely to learn that we lost more jobs last year than at any time since World War II. Just in the past year, another 2.8 million Americans who want and need full-time work have had to settle for part-time jobs. Manufacturing has hit a 28-year low. Many businesses cannot borrow or make payroll. Many families cannot pay their bills or their mortgage. Many workers are watching their life savings disappear. And many, many Americans are both anxious and uncertain of what the future will hold.” Three months later the stock market bottomed out and Americans would soon experience the longest bull market in the over 100-year history of the stock market and a 300% increase in the S&P 500 despite a slow economic recovery.

Fast forward to the last week of January this year. Even though our economy is continuing to recover, boasts the lowest unemployment in nearly two decades, and registers extremely high business confidence, we experienced a nearly 1600 point decrease in the Dow – the single largest point decline in one day.

Throughout history you will find a plethora of examples where the stock market did not act like the economy said it would. A standard metric of measuring economies is Gross Domestic Product (GDP) which measures how a nation increased the value of its production over time. Research shows that using GDP to predict stock returns isn’t wise. In fact, a Vanguard study found that GDP had no correlation to future stock returns, rendering it useless as a predictive power. Astonishingly, the amount of monthly U.S. rainfall was better at predicting future stock returns than GDP!

Contrary to popular belief, the stock market and the economy are not directly related. The economy is valued based on how productive we are collectively. The stock market is priced based on investors’ valuations that can be driven by a company’s underlying earnings, whether it issues dividends, a particular hunch, a desire to match a neighbor’s returns, or maybe even rainfall! The list can go on and on. Changes in investors decisions are not handcuffed to changes in the economy, and in many cases contradict how the economy is performing. One reason for this may be that many investors make decisions based on future expectations. So while an economy might display weak characteristics today, investors may think that it will perform well in the future, and continue to buy – which drives the price of stocks up. As Larry Swedroe astutely stated: “The big difference between the market and the economy is that the market is forward-looking, and it is unexpected events that primarily drive future stock prices. Thus it doesn’t even matter whether future news is good or bad. What matters is whether it’s better or worse than already expected… That’s exactly what has happened since March 2009.”

This is why at FJY we don’t make decisions based solely on economic conditions – nor do we try to perfectly time those decisions. Our capital management philosophy is to have a diversified portfolio of assets that perform well in bull markets and don’t collapse in bear markets. Research shows that a portfolio comprised of multiple asset classes with exposure to international markets, will outperform concentrated domestic portfolios on a risk-adjusted basis. We base the allocation of multiple asset classes on our client’s tolerance for risk and need for growth. This enables our clients to stomach bad markets and not sell at the worst possible time. We aren’t trying to beat the market, we’re trying to be the market. And with a diversification benefit we can decrease the risk of the portfolio and increase expected return at the same time. Since it is nearly impossible to predict the future and how investors will react to future events, we believe that our best avenue is to have a well-crafted portfolio that captures gains in bull markets, mitigates losses in bear markets, and allows our clients to commit to a Nobel Prize winning strategy that over the long-term is proven to succeed. Combine this with our view that an investment portfolio is simply a funding source for specific life goals, and we believe that our clients win regardless of the narrative our favorite business channels push.

Jacob Gurock