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Why Stocks and the Economy Diverge

Do you find it puzzling when a bleak economic report emerges from the press, only to be accompanied by a positive surge in the stock market?  You’re not alone.  The last few years have produced many examples of a stark contrast between stock market performance and economic indicators. So why the apparent disconnect?

Markets are forward-looking, meaning current stock prices reflect investors’ aggregate expectations for the future, while economic data primarily looks in the rearview mirror.

Market expectations and stock prices include anticipated economic developments and their potential impact on company cash flows, which are critical to a stock’s value. For example, if the market expects economic developments to weaken a company’s cash flows, the stock price may decline well in advance of when we actually observe the impact on the company, as expectations are embedded in prices.

The subsequent direction of the stock market depends on how the economic outcome compares to expectations. If reports aren’t as bad as expected, even poor economic news can be greeted with a positive stock market reaction, as happened in 2020.

Back then, headlines like “Stocks surged on one of the unhappiest days in American economic history”* were relatively common.  On May 8, 2020, it was announced that 20.5 million Americans had lost their jobs, yet all three major stock market indexes rose over 1.5%.

The dissonance tells us that the stock market had already anticipated similar unemployment numbers, or perhaps expected worse, and the market reacted positively now that some uncertainty dissipated. Market prices had responded to unemployment changes but in advance of their coming to fruition.

In the first half of 2022, we experienced the mirror opposite.  Strong employment, increased demand for goods and services, along with strong wage growth, coincided with the stock market tumbling.  How could good news lead to poor stock market performance and to Jamie Dimon speaking of economic hurricanes? Again, the market was looking forward, anticipating trouble due to geopolitical events, disrupted supply chains, and the Fed’s eventual need to increase interest rates to curb inflation.  Subsequently, as reported economic data disappointed, the stock market improved in July and August!

One can liken the disconnect to a dog walker and a dog—both travel in the same direction but may not be in lock step. The dog walker can move at a measured pace, whereas the dog may run forward and back.

There is still much uncertainty in our immediate future.  We don’t know whether the market will continue its upward climb or dip back to its lows. But we do know that markets aggregate and process vast sets of data every minute. By incorporating this information into market prices, public capital markets effectively become the best available leading macroeconomic indicator. We may feel that stock markets are ignoring bleak news when, in fact, they have projected it.

For more on markets and the economy, read Recessions and Bear Markets Explained.

*Washington Post, May 8, 2020

 

Allison Donaldson

Allison joined HTG in 2013. As an advisor, she works with clients on comprehensive financial plans and building suitable investment portfolios. She is also an integral part of the firm’s marketing team.

Allison is a CERTIFIED FINANCIAL PLANNER™ practitioner and a graduate of Hamilton College and New York University’s Stern School of Business. Allison has three sons, two of whom are out of college and financially responsible. She’s still working on the youngest.

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.
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