When we think of financial health, a few things might come to mind. We may think of our own financial status, our investments, the Dow Jones Industrial Average performance, the stock market as a whole, the economy, the country’s employment status and so on. While some aspects may be interrelated on some level, they are not all one and the same, nor do they all indicate the status of one another.
The various ways we can characterize financial well-being speaks to why so many people think of the stock market and the economy’s health as a gauge for each other. However, the stock market does not define economic health as a whole. As we’ve seen with COVID-19, stocks are back on the rise, but many individuals - and the country as a whole - are still facing the effects of business closures, record-breaking unemployment rates and more. So why is this? Below, we outline the major differences between the stock market and the economy and why they may tell different stories.
What Is the Economy?
The economy can be defined as “the wealth and resources of a country or region, especially in terms of the production and consumption of goods and services.”1 More specifically, one way we can understand economic activity is through real GDP (gross domestic product), which measures the value of goods and services while factoring inflation into the equation. As a result, understanding the health of the economy can be thought of in terms of the growth rate of real GDP, meaning whether or not the production of goods and services is increasing or decreasing.2
Economic Health in Terms of GDP and Employment
Naturally, employment may rise as production and consumption increase. To produce more goods, companies and factories might hire more employees to complete such production. With more individuals employed and gathering paychecks, more people have money to spend on such goods - increasing overall consumption. Sometimes, however, GDP can grow but not quick enough to create more jobs for those who are unemployed. 2
What Is the Stock Market?
The stock market can be defined simply as “a stock exchange.”3 It is the buying and selling of ownership shares in a corporation.4 The stock market is comprised, therefore, of the buyers and sellers (with some buyers and sellers holding more “stock” than others) and is not necessarily indicative of every business, worker and family.
Some of the main indexes used to understand how the market is performing are the Dow Jones Industrial Average (tracking of 30 leading companies), the S&P 500 Index (500 stocks across all industries), and the Nasdaq Composite Index (a dynamic mix of 3,000 stocks across the technology, biotechnology and pharmaceutical sectors).5
The Stock Market vs. The Economy in the Context of COVID-19
The stock market and the economy can display very different pictures of “progress.” One such example is with COVID-19. In regards to the stock market, the major indexes including the S&P, the DJIA and the Nasdaq Composite index all have surged since the market downturn in March.6 On the other hand, GDP decreased by five percent in 2020’s first quarter, and as of June 2020, the number of unemployed individuals rose to 12 million since February. 7,8 Why is there such a disconnect? Several key reasons below.
1. Economic data looks backwards, but the market looks forward
First, and perhaps most significantly: even in normal times, economic data looks back and the stock market looks ahead. By definition, a recession is looking back to the last six months or more. So by the time devastating economic data is released, the market has typically long been pricing it in. From there, it’s essentially just a question of whether the data was aligned with market expectations or not.10
2. The market hates uncertainty more than bad news
Second, the market hates uncertainty more than bad news. For example, back in early May, we learned over 20 million jobs were lost by U.S. workers in April. This was the worst month for job losses on record. S&P 500 futures gained and closed up 1.7% on the day that news was released. Why? The market was expecting job losses around 22 million.10
3. The next year of corporate earnings doesn’t matter that much
Lastly, even if it takes awhile to get a vaccine out, that’s not terribly long for the stock market. It is for all of us stuck in varying levels of quarantine, but in stock market time, it’s just not that long. A company’s cash flows over the next 12 months is only a small piece of the value of the stock. And that’s what you’re paying for when buying a stock: the company’s future cash flows.10
So, Now What?
So what is the path ahead for navigating this uncertainty and disconnect between the market and the economy? Have a plan going in, and stick to it.
Oxford's proprietary Power of 5 Investing® system helps take the guess work out of investing. We specialize in building portfolios in anticipation of volatility, not in reaction to it, and having a well-documented evidence based process for investing is critical to long term success. If you have questions about the market and the economy and are wondering if your portfolio is setup properly, please reach out to us HERE or email firstname.lastname@example.org to setup a meeting.