Why the Economy is Not Relevant to Investing

“I’ve always said if you spend 13 minutes a year on economics, you’ve wasted 10 minutes.” – Peter Lynch

 

Many investors believe there is some sort of cause-and-effect between the stock market and the economy. They think that if they can predict the general direction of the economy, it will help them predict the direction of the stock market and therefore their investments. However, the general direction of the economy is almost useless in predicting the stock market.

Studies (e.g. Dalbar study) consistently show that most investors buy and sell investments at the wrong times. One of the main reasons for this is because they base their decision on a mainly irrelevant factor – their outlook for the economy.

The media and professional investors very often make this same mistake. Articles about the stock market and presentations by investment companies and fund managers often include their outlook on the economy as a key part of their investment recommendations.

For example, recent articles claim now is a good time to invest because the economy is recovering from the recession, or that investors should be cautious now because of the risk of a “double dip recession”. Which one of these will happen and should this affect our investment decisions?

The usefulness of information about the economy for investing is vastly overrated. This is what we call “conventional wisdom” – something most people believe and that seems to make sense – but is false.

There are 2 main reasons why the economy is not really relevant to investing:

1. The stock market forecasts the economy, not the other way around. The stock market is the head & the economy is the tail.
2. Expectations of how the economy will perform are already built into the prices of stocks. (We will discuss this in the next article.)

 

The stock market is the head & the economy is the tail.

Let’s look at the facts. The best indicator of the economy is probably GDP (Gross Domestic Product), which is the total value of goods and services produced in a country. We calculated the correlation of GDP to the TSX60 from 1987-2010 and it is only 12%. This means that GDP and the stock market only move similarly 12% of the time.

Generally, correlations under 20% are considered “no correlation”. (Correlation of 100% means they move the same, -100% is negative correlation which means they move opposite to each other, and 0% means no correlation – that they move opposite as much as they move the same.)

For example, in 2008, the economy was fine, but the stock market crashed. In 2009, the economy was in a recession, but the stock market boomed (like it usually does during recessions).

Last year, I was asked quite a few times whether now is a good time to invest, given that it looks like it will be a bad year. My response normally was to ask: “Which one do you think will have a bad year – the economy or the stock market?” It is actually very rare for both to have a bad year at the same time.

* Data from Bank of Canada & Morningstar

There is, however, some correlation if you compare the stock market this year to GDP next year. This correlation is 33%, which is considered “low correlation”.

The reason that the stock market somewhat predicts the economy is that the prices of stocks include the future expectations of all investors in those stocks. This is confirmed by the Bank of Canada which uses the stock market as one of the key components of the “leading indicator”. This is a statistic published regularly by the Bank of Canada and used as a forecaster of the economy.

When investors buy an investment, the price they are willing to pay takes into account their expectation of how that investment will do. So, if investors are optimistic or pessimistic about the economy for the next year, that might affect the price they are willing to pay for an investment today. That is why the stock market somewhat predicts the economy.

A low correlation of 33% makes sense, though. The value of a company that is part of the stock market is normally a multiple of the profit of that company. If you talk to any business owner and ask them what affects the profit of their business, they will quickly rattle off a list of items – competition, taxes, available labour, new products, technology, cost cutting, the economy, etc. The general state of the economy is only one item in a long list of factors affecting profits.

In short, if we could accurately predict what the economy will do this year, then we have an indicator (only a 33% indicator) of what the stock market did last year. This is not really useful, since we already know what the stock market did last year! J

If we that want to know what the stock market will do this coming year, we would have to accurately forecast the economy 1.5 to 2 years from now. This is extremely difficult even for top economists to do.

So, I can settle the big debate. A “double dip recession” probably will not happen this year. How do I know? Because the stock market went up last year!

If we use the stock market for the last year as a predictor of the economy in the next year, then it looks like the economy is recovering like it always does after a recession, but possibly a bit more slowly.

A 33% indicator is not very useful. What good is an indicator that is only right 33% of the time???

You can predict the stock market more accurately by simply always predicting it will go up! In the last 25 years, the Canadian and global stock markets have been up 76% of calendar years and the US market has been up 72% of years. (Morningstar)

 

Conclusion:

In short, the reason why the economy is mainly irrelevant is that, even if you could accurately predict the economy 1.5-2 years from now, it would only help you predict the stock market for this coming year 33% of the time. You can predict the stock market far better (75% of the time) just by always predicting it will go up.

Our experience from evaluating fund managers, as a broad generality, is that the more a fund manager talks about the economy, the worse investor he is!

The next time you read an article about the economy, remember that it tells you virtually nothing about what will happen to your investments. Just repeat to yourself: “The stock market is the head of the dog and the economy is the tail.” You can’t really tell where the head is going by studying the tail.

If you are an investor, stop wasting time trying to predict the economy. The economy is not really relevant to stock market investing. It is almost useless for predicting the stock market.

 

Ed