Does economic performance always correlate with stock market performance?
When following the stock market closely, it can become difficult to understand why that day’s headlines, whether positive or negative, may have the opposite effect on the market’s performance. We’ve seen many such examples over the past few months. I’ll sit down in the morning to be greeted by stories about the harsh impact COVID-19 has had on specific businesses, industries, and entire countries’ economies only to find that the markets are on pace to surge in value. In order to understand why the market could react to economic news in such a contrasting way, it’s first important to explain how the market processes information.
The stock market is forward-looking in nature meaning that investors are making buy and sell decisions based not on what happened in the recent past, but what they expect to happen in the future. For example, a company like Apple may announce a new product today that you would expect the market to react favorably to, but if their revenue and growth projections for 2021 are cut due to COVID-19 then the stock’s price could dip despite the exciting announcement.
We only have to go back a few months to see a real-world application of the market’s ability to process forward-looking information. Although the economic impact of COVID-19 was unclear earlier this year, investors expected the pandemic to have a material impact on companies around the world. As such, markets plummeted in February and March. Investors made buy and sell decisions at that time based on future expectations even though companies may not have been impacted materially over those months. As such, markets bottomed out months before the full economic impact was made clear with the announcement of Q2 Gross Domestic Product (GDP) in late July.
Our friends at Dimensional did some additional research to further analyze the relation between US GDP and stock market performance. You’ll notice that the data reinforces our understanding that the markets are forward looking in nature. The next time you check the news and see the markets reacting differently to the day’s headlines than you might expect, it’s likely that investors’ future expectations have changed differently.
We can see this anticipatory nature of markets in action by looking at the relation between US gross domestic product (GDP) growth and equity premiums, or stock market returns in excess of one-month US Treasury bills. When annual US equity premiums are plotted against GDP growth for the same year (top panel of Exhibit 1), there is no discernible relation between the two. Changes in GDP have not been strongly related to simultaneous stock market returns.
It’s important to note that this result does not imply financial markets ignore macroeconomic data. After all, GDP encompasses several measures of the economy, not just corporate profits. However, while GDP may be an imprecise representation of the activities that ultimately drive stock prices, further analysis shows that is not the sole cause for the lack of relation between GDP growth and simultaneous equity premiums.
Plotting GDP growth against the previous year’s equity premium (bottom panel of Exhibit 1) reveals a noticeable relation. The positive trend in the data suggests market prices have in fact reacted to changes in GDP but have done so in advance of these economic developments coming to fruition. This result is consistent with markets pricing in their expectations of economic growth.
Please see the end of this document for important disclosures.
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