Does the Economy Predict Stock Returns?
Investors, economists and the media spend an enormous amount of time and energy trying to forecast the economy. The idea is that forecasting economic growth will give us an idea of where the stock market is headed. Surprisingly, no predictive relationship exists between current economic conditions and the current stock market.
US Gross Domestic Product (GDP), a measure of the overall output of the US economy, grew at an average rate of 6.5% before inflation over the past 58 years. The GDP growth rate itself was relatively stable and positive in all years but 2009. Contrast this with erratic annual stock price changes, ranging from a gain of 34.1% in 1995 to a loss of 38.5% in 2008. Stocks appreciated in 72% of the years but delivered a significantly higher average annual growth rate of 11.1%.
NOMINAL US GDP AND S&P 500 PRICE INDEX CALENDAR YEAR PERCENTAGE CHANGE (1961 – 20181)
Source: S&P Dow Jones Indices LLC, Bloomberg | Note 1: 2018 figures are partially based on estimates.
Over the long-term, stock prices rise as economic output rises. But over shorter periods like calendar years, there can be large discrepancies between economic growth and the stock market. Like a supertanker, the overall economy changes course slowly and absorbs most short-term disturbances in its steadfast advance. GDP is widely used to measure this advance, but it is a trailing metric that is frequently revised, so it is not particularly timely or accurate.
Stock prices, on the other hand, incorporate investors’ forward-looking estimates of economic growth. These estimates contain a great deal of uncertainty, which introduces dramatic price swings as new information becomes available and investors’ expectations shift. The stock market remains one of the best predictors of the economy six to nine months into the future, but this relationship is weak and the market is still wrong about the economy the vast majority of the time.
By the time individual investors become aware of economic conditions, any real or perceived economic factors are likely already priced into the market. So, stop worrying about the economy, stay fully invested and stick to your long-term investment strategy.
From the Behavioral Viewpoint
What is going on?
- With their constant drumbeat about geopolitics, economic forecasts, fed-policy and political jockeying the media and politicians create an availability bias, the tendency to believe things that come readily to mind are more representative or important than is the case.
- We are pre-conditioned to believe the narrative that current economic conditions drive stock prices. In fact, it works the other way around with the stock market currently pricing in future expectations of the economy.
- As a result of fallacy of control, we want to predict market movements based on economic data and then act upon those predictions. Unfortunately, short-term market movements are largely random.
What can we do?
- Understand that while important to many aspects of our lives, economic growth is not particularly helpful in predicting near term equity market movements.
- Ignore economic data and short-term market volatility. Reap the benefits of higher stock returns as a long-term investor by staying invested throughout economic and market cycles.
- Work with a financial advisor who can provide valuable perspective, discipline and coaching to help you stay on track towards your long-term goals.
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