The disconnect between stock prices and the economy

The disconnect between stock prices and the economy

The disconnect between stock prices and the economy

Data shows that not only do stocks not follow changes in GDP, it's actually GDP that follows changes in stock prices

Data shows that not only do stocks not follow changes in GDP, it's actually GDP that follows changes in stock prices

Data shows that not only do stocks not follow changes in GDP, it's actually GDP that follows changes in stock prices

A DEAFENING chorus has emerged since the stock market bottomed in late March and then staged a fast rebound that caught everyone by surprise, even as the pandemic numbers continued to grow:

How can the US stock markets be only down 15 per cent from all-time highs, when we are facing the worst global recession in a century, worse than even 2008?

The conclusion from this train of thought is that current stock prices are 'crazy' in ignoring the dire economic fundamentals, and that another crash is imminent when either a second wave of infections hits, or the mass bankruptcies in the economy come due. Stock markets will often act in ways counter to the consensus view of the majority of investors, as we are experiencing now.

The strongly held view of a second (and even a third) wave of infections coming is based on a historical sample of one: the 1918 Spanish Flu had a second wave which was much worse than the first one. Any statistician will tell you that such a sample size is of zero predictive ability. Sars had minor second waves in isolated locations that were far less lethal than the first wave.

Comparisons to 1918 also throw up all sorts of problems - World War I had just ended, and the world has made massive advances in medicine since then. Initial data is indeed pointing to possible second waves in Wuhan and South Korea, but governments around the world also have much more information compared to two months ago on the lethality of the virus, and are better able to assess the risks of opening the economy even in the face of higher infection rates. The highly feared situation of countries running out of hospital beds to help all the infected, which was considered a 'base case' by some epidemiologists, never came close to occurring, even in countries like Sweden which did not institute an economic lockdown.

Investors with a negative outlook are underestimating the capability of the world's medical research resources, which have been largely redirected towards finding a cure and vaccine for Covid-19.

What about the disparity between stock prices and the economy? Many major economic data points have literally gone off the charts in the negative direction. We have the largest ever monthly unemployment figures and the quickest fall in quarterly GDP. How can stock markets only be off their all-time highs by the equivalent of a mild correction?

We are continually reminded that stock prices follow GDP, but this relationship is wrong. If you could trade the stock market on perfect foresight about next quarter's GDP, you would lose out to the buy-and-hold investor. Quarterly GDP has a near zero correlation to stock market performance. Data actually shows that not only do stocks not follow changes in GDP, it's actually GDP that follows changes in stock prices. The ability of markets to look forward by six to 12 months is often misunderstood. Does the stock market have some kind of crystal ball that foretells the future?

No. It merely aggregates all current knowledge far better than we humans can. It can sometimes overshoot, like at the end of bubbles and during panics, but these large excesses are quickly corrected. Instead of using GDP as an input to forecast future stock markets, current stock trends should be used as one of the inputs to forecast future GDP.

In times of very conflicting signals between the economy, investor consensus, and stock price action, it is useful to remember the following advice:

"The level of stress an investor feels is directly proportional to the amount of time spent agonising about how the stock market should be performing, versus how it actually is performing."

We are continually reminded that stock prices follow GDP, but this relationship is wrong. If you could trade the stock market on perfect foresight about next quarter's GDP, you would lose out to the buy-and-hold investor. Quarterly GDP has a near zero correlation to stock market performance. Data actually shows that not only do stocks not follow changes in GDP, it's actually GDP that follows changes in stock prices. The ability of markets to look forward by six to 12 months is often misunderstood. Does the stock market have some kind of crystal ball that foretells the future?

No. It merely aggregates all current knowledge far better than we humans can. It can sometimes overshoot, like at the end of bubbles and during panics, but these large excesses are quickly corrected. Instead of using GDP as an input to forecast future stock markets, current stock trends should be used as one of the inputs to forecast future GDP.

In times of very conflicting signals between the economy, investor consensus, and stock price action, it is useful to remember the following advice:

"The level of stress an investor feels is directly proportional to the amount of time spent agonising about how the stock market should be performing, versus how it actually is performing."

When stock markets perform as we expect, there is no stress. When markets do the exact opposite of what we think they should be doing, and continue to do so for what feels like an eternity, we experience enormous stress. We do not know if we should be buying more, hold on to what we have, or sell now after the recent rebound, expecting a second crash. These questions are magnified for anyone who sold on the way down at levels below where markets are now and is missing out on the rebound.

During such times it is critical to objectively assess how much personal bias is influencing how we think the markets should be acting, as we are bombarded daily with news about the virus, and investment commentaries which are mostly negative or 'cautious'. Instead, since the stock market itself has predictive power and is also the determinant of our investment portfolio's profit and loss, we need to continuously and objectively assess the daily movements in relation to the news.

For example, one of the companies that is in the running for a Covid-19 vaccine is Moderna Inc, listed in the US. On Monday, US equities gained 3.1 per cent on news from Moderna that the tests of its vaccine "couldn't have been better". The next day, a respected medical journal website suggested that the Moderna announcement meant little. US equities promptly fell 1.3 per cent. This kind of market action, when more weight is placed on positive news than negative news, is not bearish and stands in stark contrast to current investor sentiment, which continues to be overwhelmingly bearish.

This daily monitoring and assessing of market action is a full-time job and a big contributor to one's stress levels, which is why most investors would always be better served by not selling in a downturn and remaining invested, or better yet adding more during downturns, at pre-determined prices that match their risk profile. For ones determined to trade the markets, focus more objectively on what the market is doing now, rather than your idea of what it should be doing. If you do this well, you'll see hints of any actual deterioration in stock market action and can act accordingly.

By LEONARDO DRAGO

Co-founder of AL Wealth Partners, an independent Singapore-based company providing investment and fund management services to endowments and family offices, and wealth-advisory services to accredited individual investors.

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