Published August 7, 2020
One of the favorite sources of news and discussion topics in the financial media is the economy and speculation about its future health. Everyone knows that economies, whether local, national or global, repeatedly go through boom and bust cycles. These business cycles affect all of us to some degree but many in the investment community pay particular attention to them because of a fundamental belief that as the economy goes so goes the stock market. As shown in the chart below, there is little doubt that economic and market cycles are somehow linked and that they influence each other, but we do not believe that many of the much touted economic indicators can be used by investors to accurately and reliably forecast the future of the stock market.
Economics, often referred to as the “dismal science” since Thomas Carlyle coined the term in the nineteenth century, are really the study of how society behaves in the struggle between unlimited wants and limited resources. Today, an entire industry thrives on the creation, monitoring, reporting and interpretation of a multitude of economic indicators such as employment, consumer sentiment, inflation, interest rates, inventories, price of raw materials food or energy, trade deficits and many more. The Commerce Department, the Labor Department, academic institutions and numerous think tanks crank out an endless stream of numbers. Econometrics then applies statistical theories to economic ones for the purpose of forecasting future trends. While much of this is way above our heads, the complex web of causes and effects between the multitudes of variables in society is backed by much research and for the most part seems quite logical. Most of us can follow simple scenarios such as growing unemployment negatively affects consumer sentiment, which in turn reduces their level of spending causing increased inventories. The reduced demand for goods causes prices to drop and manufacturers to slow down production and so on and so forth.
The disconnect occurs when trying to interpret all of this data in order to issue stock market forecasts. As with all market interpretations the result is highly dependent on the interpreter’s point of view, the market context, and the then prevailing investor psychology. Depending on these conditions the same set of economic data can lead to diametrically opposed conclusions, which helps explain why so many respected expert forecasts are dead wrong. This is best illustrated with practical examples.
Example 1: Higher interest rates are bad news for the stock market (and vice versa)
Or are they? Since 2008, the Fed has pushed interest rates as low as they could in order to rescue a depressed economy. At first, it is interpreted as a good thing for the stock market, but it is often a perfect opportunity for highly regarded economists and pundits to contradict themselves. They would later say that lowering interest rates is not enough to restore confidence in the economy, and that the roots of the disease are much deeper. The perception of what the Fed does is highly subjective. Sometimes, what Ben Bernanke says or does not say is more important than what he does.
Example 2: War is good for the economy and the stock market
While this theory has long ago been proven to be fundamentally flawed by economists, investors and politicians hold on to the myth. The simplest way to explain this one is with the “Broken Window Fallacy”. The story goes something like this: a punk throws a rock through a storefront window which has a visible set of consequences. The shop owner has to pay the glass maker $1,000 to fix it. This $1,000 causes the glazier to purchase more raw materials from other merchants and hire employees to make the window, who in turn can spend their new earnings. The logical conclusion is that the punk, far from being a vandal, is actually an economic benefactor to society. Economists then like to point out that he has actually caused a net decline in the economy. Instead of having a window and $1,000 the store owner now only has a window. He could have spent the $1,000 to buy a suit, so he would have a window and a suit, and the $1,000 he paid for the suit would have generated the same economic boon as when he paid the glass maker. In similar fashion the war has to be funded by a combination of reduced spending elsewhere, higher taxes and/or higher debt, all of which are bad for the stock market.
Example 3: Rising unemployment is bad news for the stock market
Or is it? Research tells us that it depends on which phase of the economic cycle we are in. Announcements of rising unemployment tend to be good news in economic expansions during which investors worry more about interest rates. News about higher unemployment reduces the risk that the Fed will increase interest rates. The same exact news will on average be perceived as bad news during an economic contraction, as investors tend to be more worried about corporate dividends and equity risk premiums which can be negatively affected by layoffs.
Now that we better appreciate the difficulty in using economic leading indicators to forecast the stock market we can also point out that in fact the stock market itself just happens to be one of the most reliable leading indicators of the economy’s future direction. Not the other way around. In mysterious ways the stock market anticipates what is coming. A bear market always reaches its bottom while the recession is still worsening, well before economic recovery begins. The falling interest rates and prices provide the consumer a glimmer of hope which in turn triggers the next bull market cycle and in turn a recovery begins. As the economic recovery gains steam, prices start inching up, the Fed ends up raising interest rates all over, and consumer expectations start declining as the stock market peaks. And so on.
As Trend Timers we prefer to watch the market itself for clues of what it is doing. Following the market trend is much simpler and more reliable than reading economic tea leaves.
Investors kicked off the month of August Monday with solid gains. Reports affirming a recovery in global manufacturing offered support, as did news that Microsoft was in talks to buy the hugely popular social media app, TikTok. The S&P 500 closed with a +0.7% gain on the day. Another +0.3% was added Tuesday as investors slowed down, turning their attention to negotiations for the next round of Covid stimulus from Washington. Another +0.6% rise Wednesday with the stock of Disney gaining almost +9% on news of strength in its Disney+ TV streaming service. Payment processing firm Square also rose sharply on earnings. A downtick in jobless claims encouraged markets Thursday. Another +0.6% advance rode strength in Apple and Facebook, the latter jumping +6% on news the firm launched a short-feature video service for its Instagram platform, a direct competitive offering to TikTok. Friday delivered a mixed market with small-cap stocks rising while the leading Nasdaq index took a hit. An executive order aimed at China hurt tech stocks. The monthly jobs report was encouraging enough to send Treasury yields higher lifting financial stocks. But the stimulus deal soured to keep most stocks in check. The net effect was a flat day for the S&P 500.
Another strong week for stocks found the S&P 500 rising by +2.47%. The Nasdaq 100 (QQQ) added +2.14% in breaking above $270 for the first time. The small-cap Russell 2000 (IWM) made up some lost ground with a +5.98% surge.
Warm wishes and until next week.