The Relationship of The Stock Market And Our Economy

Thus far, 2022 has been a bumpy ride for the stock market and economy. Investing in the market is more challenging when you have high inflation, rising interest rates, and supply constraints caused by the Ukraine conflict and lockdowns in China.

It’s hard to succeed in the market when you’re feeling the higher prices at the grocery stores, gas stations, and others. The Fed is resetting its monetary policy to a contractionary one to tighten the economy. They are raising their interest rates (i.e., fed funds) to cool down the highest inflation in 40 years. Some investors fear the Fed may push us into a recession, which is not suitable for investing. 

The relationship between the stock market and our economy may seem interchangeable, but they are different. Unemployment rates are low, but workers demand higher wages to pay for basic needs that cost more. It becomes harder to save money. We’ll discuss how the market and economy relate to each other. 

 The Stock Market And Economy: Latest 2022 Statistics

The unemployment rate in April 2022 was 3.6% remains low. It remains low and that’s excellent news.

Real GDP in the first three months of 2022 contracted by 1.4% annually, down significantly from the 6.9% recorded in the 4Q 2021. This surprised economists, though some temporary issues pushed down the number. It raised concerns about a recession, defined by two consecutive declines in GDP.

Inflation in April measured by CPI was 8.3%, slightly down from the 8.5% reported in the previous month and still near the highest levels in 40 years.

The personal savings rate was 6.2% for March 2022, continuing its decline in recent months, likely impacted by consumers paying higher prices.

The US Index of Consumer Sentiment provided by the University of Michigan dropped to 59.1 in May 2022, down from 65.2 in April 2022.

Real consumer spending grew 2.7% in the first quarter of 2022, compared to 2.5% in the fourth quarter of 2021. Consumer spending is a key indicator of economic growth as it accounts for 70% of GDP.

The S&P 500 index reflects a decline of 15.6% as of May 13, 2022, since year-end 2021, after knocking the ball out of the market in 2021, with a 21.34% increase. 

   

 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. Growth in our economy varies over time according to business cycles.

The phases of business cycles are expansion, peak, contraction, and trough.  The expansion phase is most favorable for stocks to rise as economic production is at high capacity, strong retail sales, low unemployment, and relatively low-interest rates, increasing consumer demand to buy houses and cars. The contraction phase occurs when the economy falls, and the trough is the economic bottoming that typically leads to expansion.

However, strong demand can lead to an economic peak, higher inflation, and Fed intervention to raise interest rates to slow the economy and hopefully avoid a recession. This scenario is where we are now. The Fed plays a significant role in righting our economy whether experiencing higher inflation or a weak economy.   

Gross domestic product (i.e., GDP), unemployment, inflation, consumer confidence, inflation (e.g., CPI, PPI), and many other indicators reflect economic conditions.

As a leading economic indicator, the S&P 500 composite index represents the market proxy and often predicts a recession or economic recovery. The S&P 500 index captures the stock movements of 500 of the largest publicly traded companies. Besides that index, investors look to the widely known (but less important)  Dow Jones Industrials, NASDAQ composite index, and the US Russell index for smaller cap companies. 

A rising stock market often indicates improving or more favorable economic conditions for firms, resulting in higher revenues and profitability. On the other hand, a declining stock market may signal softer economic conditions, signaling a potential downturn or recession. 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 Has Been Volatile In 2022 

The longest bull market began in March 2009, ending on March 23, 2020, when the S& P 500 index bottomed on March 23rd at $2,237.40, transitioning to a relatively short bear market. From that March 23rd bottom to December 21, 2021, the market soared to $4,766.18, reflecting a 27.7% increase in 2021.

Thus far, S&P 500 index is down 15.6% in 2022 through May 13, while the tech-heavy NASDAQ composite is down almost 25%. 2022 began with stock valuations at historically high P/E levels of 23, and have come down to a cheaper level of 16-17 P/Es.  Some investors are hopeful that high inflation may be nearing its peak, and better stock performance may be ahead. Stock market volatility is likely to continue throughout this year.

Are We in A Bear Market Yet? Probably

A question that keeps coming up: are we in a bear market or a market correction now? You need to define those terms and crunch some numbers to answer that question. The quick answer is that we are beyond a market correction, a 10% decline from the S&P 500 peak, and we are getting closer to bear market territory, which is a 20% drop from its recent high. However, many tech growth companies in S&P 500 index are already in a bear market. 

We are facing challenging economic factors which will take some time to stabilize. The market is likely to be volatile, both on the downside and the upside. Let’s leave aside the various market definitions which we define here.

A weak market provides buying opportunities if you have savings to put into the market. It is best that investors not sell stocks in panic unless they need to do so for liquidity purposes. Having an emergency fund is essential in providing liquidity to cover your living expenses during unforeseen events. As interest rates rise, your savings bank accounts will reflect higher rates, incenting consumers to save more money. 

How Far Can Stocks Fall? It Depends

The Fed is in the early stages of raising interest rates which affect most interest rates in our economy, especially borrowing rates. From historically low rates below 4%, 30-year mortgages are above 5% now.  

With a 3.6% low unemployment rate, we are where we were in 2019 when the economy was sound. The biggest question is whether the Fed’s actions can bring down inflation from the 8.3 % rate to their targeted inflation rate of 2%  before unemployment goes up because companies start to do less hiring and some downsizing of their workforce.  

The continued move in stocks will be dependent on these factors and whether we enter a recession.

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. 

 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. Understanding why unemployment matters, which you can read here.

 What Stocks Reflect

How quickly will our economy recover? It may take until 2023 for the Fed to control inflation, but moderation of higher inflation will be good news, and stocks may respond quickly to news that rewards or punishes investors. Avoiding a recession will be excellent news, and Chair Powell says he hopes the Fed can prevent it, but there are no guarantees. 

Market sentiment is a measure of the general mood of investors in the stock market. As stocks remain volatile, the market may give back some gains if there is no further favorable news to support the stocks’  valuations.

Stock valuations reflect expectations for the future. Based on optimistic expectations, you can make money in the market, even in a weak or recessionary environment. Stocks rose during the Great Recession, particularly in March 2009, after the economy hit the trough, the lowest part of the business cycle.

Stock valuations measured by the S&P 500 price/earnings or P/E multiple had run as high as the low 20s, with some growth stocks closer to 30. With the recent market corrections, the S&P 500 multiple is now closer to a more reasonable 16 multiple, more in line with 10-year historical ranges in the mid-teens. These lower valuations could bring more investors back to the market.

However, existing economic conditions do not always negatively impact stock market performance in tandem. A firm’s stock may be affected by its industry’s needs or relative strength.

2. Industry-Related Matters

Using the March 2020 bear market as an example, specific industries and their stocks–airlines, automotive, energy, hotels, brick & mortar retail, and 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, notable leaders in e-commerce, telemedicine, video conferencing providers, gaming companies,  video-streaming,  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. As soon as the pandemic was under control, those stocks sold off in late 2021, and continue to do so in 2022.  

What Industry Do You Want To Invest In

With stock market volatility and concerns about a possible recession, we think that investors can add some recession-proof stocks of companies that tend to be more resilient when the economy weakens.  Specific industries, like health care, consumer staples, utilities, and discount retailers, are more recession resistant and attractive to consumers.   

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, in demand.

On the other hand, if you are looking for reliable income and dividend growth, consumer staples (e.g., Colgate Palmolive) that produce and sell everyday necessities may be the right answer. You can consider the Dividend Aristocrats individually or 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 sectors 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 dependent on the FDA and going through many trials. 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 buying or selling. Specifically, understand the 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.

Although we discuss stocks in this post, with inflation at high levels, investors should invest in the Series I government savings bonds now paying returns of 9.62% as of May 1, 2022!

 

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. 

Sometimes a 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 shift away from these tendencies 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 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 common biases we use when investing, which you can read here.

Final Thoughts

We are entering a new economic era, with high inflation, expected higher interest rates, and continued supply constraints. We are feeling the strain of higher prices for consumer products we need. For many of us, the intrigue of the Fed working to bring down inflation without pushing us into a recession is an abstract concept.

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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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