The Relationship of The Stock Market And Our Economy

2020 was a remarkable year of extremes for the stock market and economy. The relationship between the stock market and our economy may seem to be interchangeable but they are different.   Lockdown mandates due to the pandemic hurt the economy, causing the highest unemployment since the Great Depression, which only in recent months is showing strong job growth. On the other hand, the stock market nosedived, entering a 33-day bear market before swiftly recovering.  

As Delta cases rise to substantial levels, it is fair to worry that it may set back our economy. No one wants to revisit lockdowns, which caused unemployment and supply strains we are still experiencing.

The Improving Economy 

The July 2021 unemployment rate reported by the BLS was 5.4%, down from 14.7% in April 2020. Walk down streets in your neighborhood and you are bound to see “Help Wanted” ads. Federal unemployment benefits run out after Labor Day so many more people will returning to the workforce. 

 

Relationship Between The Stock Market And Our Economy

Stock prices move on expectations about the future, as news conveys information related to the economy and the direction of interest rates.  Generally, the relationship between the stock market and our economy often converges and departs from each other. Gross domestic product, unemployment, inflation, and many other indicators reflect economic conditions.

As a leading economic indicator, the S&P 500 composite index represents the market proxy, is often predictive of a recession or economic recovery. The S&P index captures stock movements, along with the widely known  (but less important)  Dow Jones Industrials, and NASDAQ composite index.

A rising stock market may indicate favorable economic conditions for firms, resulting in higher profitability. On the other hand, a declining stock market may signal an economic downturn. Over the long term, these trends are likely to show the economy and stocks in tandem. Day-to-day, those correlations may be harder to see.

Stock Market Turbulence During The Pandemic

After the S& P 500 index peaked at $3,386.15 on February 19, 2020, the market bottomed on March 23rd at $2,237.40. This swift 33.9% decline marked the transition from a longstanding bull market to a bear market. Market volatility in that one-month timeframe was unprecedented. There were 18 market jumps greater than 2.5% in 22 trading days (February 24 to March 24, 2020).

The substantial rise in stocks has responded to our economy’s opening as lockdowns ease, and people return to work. That was not all to record-setting stock price movements as sudden as the S&P 500 index was its rally back to $3,193.93 on June 5th close. That is an astounding 42.8% climb through the latest close. The market is nearly back to the February 19th peak.

Bear Market Rally Or A New Bull Market

A question that kept coming up: did we experience a bear market rally or a new bull market? We explain the difference between a bear market, a bear market rally, and a bull market. Generally, a bull market occurs when a rise of 20% or more in a broad market index over at least two months. Investopedia defines a bull market as when stock prices rise by 20% after two declines of 20% each.

Let’s leave aside the various market definitions. We faced extremes with the coronavirus’s impact on our markets, economy, lockdowns, and our lives. When the markets initially plunged, we suggested that investors not sell stocks in panic unless they needed to do so for liquidity purposes. Having an emergency fund is essential in providing liquidity so that you cover your living expenses during unforeseen events. I think we can agree that the coronavirus was such an event. We pointed to the Great Recession as a recent example of why you should avoid selling stocks at a market bottom.

How Far Can Stocks Rise? It Depends

With some early signs of economic improvement, do the stocks continue to rise? That depends on whether there will be future upside surprises to indicators that matter. 

Let’s face the fact the current 5.4%  unemployment is still a high number with room for improvement to the mid 3% range which is low and where we were in 2019. 

The continued rise in stocks will be dependent on how fast and far unemployment rates decline and inflation remaining at moderate levels. 

3 Fundamental Factors That Affect Stock Prices

Typically, a company’s value should reflect the present value of its future cash flows. To calculate future cash flows, investors should consider several factors that affect whether the stock is overvalued or undervalued. 

Three key fundamental factors: 

1. The Economy

Investors look at how economic growth drives demand for the company’s products and services: the more substantial the need, the stronger the company’s revenue, cash flows, and potential valuation. When investing, you should have a basic knowledge of the economy and the Fed’s role in correcting economic changes. Those changes could indicate a weakening economy, direction of interest rates, or higher inflation. We believe in understanding why unemployment matters, which you can read here.

The severity of the coronavirus and government action encouraged social distancing and lockdowns. As a result, there were alarming changes in economic indicators, signaling a recession. With a low 3.5% unemployment in February 2020, our economy was healthy, then rose to 14.7% in April. Weekly initial claims for unemployment insurance and its four-week moving averages tend to be a better economic gauge. They rose as we experienced the virus’s impact on our lives. Jobless numbers started to grow in the hundreds of thousands by late February, then millions of people in March. Even now, the unemployed levels are still rising at high rates, though they improved from the initial claims in March and April.

From the start, this economic decline was different from previous recessions. Our economy’s downturn was event-driven by a coronavirus, but that doesn’t make it less devastating. Economic activity ceased as many remained sequestered at home.  When unemployment rises, consumers spend less, and businesses suffer. Layoffs and furloughs resulted, mostly if workers could not work remotely. Essential workers were feverishly needed to do jobs despite the threat of the virus. They weren’t shopping either.

High Personal Savings Rates

Rather than spending, personal savings rates rose to a record level of 33% in April 2020. That’s another indicator that consumers hoarded cash out of fear or reduced consumption as we stayed home. That’s a good news-bad news story. Personal savings are essential to build as an emergency cushion, reduce high debt levels, or invest in assets. Americans had been lagging in savings rates for years. The current rates have been normalizing to 9.4%, just above the 8.2% before the pandemic. Ultimately, people have been experiencing life post-pandemic, with higher pent-up demand and consumer spending.

What Stocks Reflect

How quickly will our economy recover? Economists talked about V and W recoveries to reflect the shorter period to return to normalcy.   Stocks respond quickly to news that either rewards or punish investors. Uncertainty becomes an overhang and if the Delta cases continue to rise, the market may reflect that negative news. Market sentiment is a measure of the general mood of investors in the stock market. As stocks rise, the market may give back some gains if there is no further favorable news to support the stocks’ higher valuations.

Stock valuations reflect expectations in the future. You can make money in the market, even in a weak or recessionary environment, based on optimistic expectations. Stocks rose during the Great Recession as they have during the past year. However, existing poor economic conditions do not always negatively impact stock market performance. A firm’s stock may be affected by its industry’s conditions or its relative strength.

2. Industry-Related Matters

Specific industries and their stocks–airlines, automotive, energy hotels, brick & mortar retail, restaurants-swiftly bore the brunt of the initial market decline due to the coronavirus impact. On the other hand, other industries benefited from the stay-at-home lockdown measures. Those were online businesses, notably leaders in e-commerce, telemedicine, video conferencing providers, and those with potential vaccines or testing equipment. Many investors made changes to their portfolios. They sold specific stocks they anticipated would be most hurt by the lockdown, rotating into the newer winners. I made some of those changes to my portfolio. Additionally, as the market seemed riskier, I bought more dividend-bearing stocks of companies with solid balance sheets.

With the fear of Delta cases rising, some of the stocks that did better during the lockdowns are being bought again, while the airlines have been trending down. With half the country vaccinated, I don’t believe we are going into lockdown mode. Hopefully, I am right!

What Industry Do You Want To Invest In

Generally, industry factors matter when picking stocks for your portfolio. What makes an investible industry? It may depend on what you are seeking.  If you are seeking growth, technology could be a profitable sector. Look at some of the various subsectors, such as cloud companies, very much in demand. On the other hand, if you are looking for stability, consumer staples (e.g., Colgate Palmolive) that produce and sell everyday necessities may be the right answer. You can consider the Dividend Aristocrats as a group through NOBL. 

You want to look at industries with dominant companies that can ward off competition in a profitable sector. On the other hand, avoid industries that may be subject to new regulations that hurt margins.  Once you decide on an industry you want exposure to, look at the best companies in that group. Investors compare relevant price to earnings valuation of a stock compared to its peers based on its competitive advantages, margins, market share, and management. Sometimes stocks or their industry may be in an infancy stage of development and may not necessarily generate earnings yet like early stage biotechs that are dependent on the FDA. Then, in that case, investors use other valuation metrics such as a multiple of revenue or cash flow or are event-driven.

3. Company-Specific Aspects

Learn about the company you are considering to buy or sell, specifically, understand that company’s relevant factors and its valuations. Investors look at specific expectations for growth in revenues, cash flow and earnings, balance sheet strength (e.g., liquidity and debt ratios), and corresponding valuation. To consider a company’s strength,  look at some of the personal financial ratios relevant for investing.

Positive earnings surprises may send a stock soaring, while a negative earnings surprise may prompt a stock to decline. Investors like to see mergers, acquisitions, and divestitures that may benefit one or both companies as they fill a void in their business portfolio or raise capital from a sale.

Investment Biases Affect Decisions

Volatile markets and economies impact our emotions. The more turbulent the market, the greater the likelihood we may be affected by our biases. Generally, we make investment decisions by relying on fundamental analysis to determine if a security is undervalued. If the stock market is efficient, the stock prices are rationally priced, fully reflecting all available information. As investors, we try to capitalize on discrepancies in a particular stock or new report not already accounted for to profit on that position.

Sometimes stock may be mispriced because of the psychology involved in decision-making known as “behavioral finance.” This discipline can offer behavioral/emotional or cognitive biases to explain why markets or stocks are moving in a certain way. Learning about these biases can help us to shift away from these tendencies away and invest more wisely.

Having biases–cognitive and emotional– may cloud our judgment when making investment decisions. Since the coronavirus pandemic, we have changed many of our consumer habits to protect ourselves from exposure. We have quarantined ourselves to practice social distancing, buying products in bulk, and shopping online. Now we are slowly reversing ourselves as we come out of lockdowns. Be aware of some of the common biases we use when investing, which you can read here.

Final Thoughts

We are in extraordinary times. The coronavirus caused a public health crisis and an economic crisis. Although the economy is far from recovery, there have been opportunities to make money in the financial markets. The S& P 500 has set multiple records during a weak economy as it predicted we could have an improving economy. High unemployment levels took time to improve to nearly normal levels as people returned to work. 

Thank you for reading this article! Please visit us at The Cents of Money where you find other articles of interest, and become a subscriber to our growing community.

 

 

 

 

2 thoughts on “The Relationship of The Stock Market And Our Economy”

  1. Hi Linda
    Great stuff and very informative. Would you know if there is a chart of some sort which shows changes in the stock market with economic, global, political, etc events on the chart(s) itself.
    Cheers
    Ben

    Reply
    • Hi Ben,
      Thank you for your feedback!
      I sometimes see charts where you can insert specific information such as recessions, corrections, Fed policy changes, especially in the college textbooks. There are some chart services that one can use but they can be quite pricy. From time to time, I play with charts and then manually put some specific events. Statista is one of the free chart services for event at a time (eg. rising oil prices) that I sometimes use for a variety of topics.
      Wish I could be more helpful, I think charts can be extremely useful. Among online brokers, Webull has the best charts.

      Best,
      Linda

      Reply

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