The economy is not the stock market

There is zero correlation between economic growth and stock market returns, Brown writes. They head in the same direction over time, but the stock market and the economy are only loosely related.

I had an on-air debate with CNBC's Steve Leisman the other day about why investors and traders shouldn't fuss too much over economic data (unless they're trading based on it each day).

It's a difficult concept to grasp when you're trained to look for narratives and storylines as most journalists are. Steve is a very good economic reporter and brings a wealth of information to the viewers each time he's on. I was simply trying to make the point that the Greek stock market had risen by 30% last year despite a contracting economy while in Shanghai stocks were down all year as the Chinese economy grew by 7%.

Thus, the Economy ≠ the Stock Market.

The truth is, prior to 2007, the most successful investors completely ignored the economy except at major turning points when it became a crossover story for the news reports.  Valuation and corporate profits were of more interest to the Wall Street crowd and economists were relegated to the bench. This shifted five years ago and gave rise to the Rock Star Economist archetype - someone who could explain big picture trends to the troops who had not, until that point, ever paid any serious attention. 

The pendulum is starting to swing back in the other direction and the macroeconomic stuff is getting less interesting to pay attention to with every passing day. Because for investors, once you understand the basic environment you're in, there's not much point to comb through every release for the finer details.

It's not that the economy isn't important to understand - it is. It's just that it matters way less than those who are fascinated with the topic really understand.

And, as The Economist explains this weekend, there is zero correlation between economic growth and stock market returns anyway. Sure, they head in the same direction over time, but they are only loosely related.

Consider:

Think of the market as driven by the change in corporate earnings and the rating applied to those earnings (a truism). Domestic earnings depend not just on the GDP growth rate but on the level of profits relative to GDP; and international earnings depend on the strength of the world economy, currency movements etc. Profits are very high relative to GDP in the US at the moment which is partly down to international operations and partly down to the sluggish nature of wage growth; the latter may be good for the corporate sector but not for the economy as a whole.

The rating of earnings may be affected by a number of other factors including the optimism of investors, the creation (or destruction) of new equities by the corporate sector and the attractions of alternative assets. So there is a lot going on.

and:

"take the records of 83 countries from 1972 to 2009 (the most comprehensive set available) and rank them by GDP growth over the previous five years. Investing each year in the countries with the highest economic growth over the preceding five years earned an annual return of 18.4%, but investing in the lowest-growth countries returned 25.1%."

Again, cognitively this is a tough concept to swallow - we love stories that have a beginning and an end, that have features and aspects to them that confirm what we already suspect. This yearning for a narrative is deeply ingrained in us and has been responsible for our survival as a species. Story is how we pass on crucial wisdom and knowledge to the next generation. But it doesn't always work in stock market investing and the economic story doesn't always "confirm" the stock market activity you see before your eyes.

Source:

Growth and the markets (The Economist)