Many assume that a stock market’s direction depends on an economy’s well-being. It does not. In fact, a meaningful correlation between stocks and gross domestic product does not exist.
Why, then, do the financial media focus so intently on the current state of an economy? Presumably, if consumers and businesses are less capable of purchasing products and services from publicly-listed companies, then those companies may struggle to generate the profits that drive the perceived value of share prices. Yet its not the economic condition itself that causes the decline in share prices; rather, it is the fear of economic stagnation turning into economic collapse that sends share prices dramatically lower.
Some folks already understand that fear and greed move market-based securities. Writers and readers alike enjoy quoting Warren Buffett along the lines of being greedy when others are fearful or fearful when others are greedy. In fact, stocks often have their biggest gains smack in the middle of recessions and their largest flops in anticipation of sharp economic downturns. For instance, even though the Bureau of Labor Statistics (BLS) records the 2007-2009 recession as having started in December of 2007, the powers-that-be did not identify 12/07 as the start date until ten months later (10/08). In contrast, the stock market anticipated trouble a full year in advance (10/07) of economists.
It follows that investors can think of stock markets and bond markets as “forward indicators†of economic direction. A stock market that enjoys a significant uptrend can be indicative of economic improvement, while a treasury bond market that enters a significant uptrend can be indicative of hardships ahead. Indeed, one often expects U.S. Treasuries and stocks to move in opposite directions over a period. Conversely, when these asset classes move in the same direction for a length of time, the treasury bond market’s fear is not in sync with stock investor greed.
