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.

stockmarketeconomy

* 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!  :)

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.

About the Author: Ed Rempel is a Certified Financial Planner (CFP) and Certified Management Accountant (CMA) who built his practice by providing his clients solid, comprehensive financial plans and personal coaching.  If you would like to contact Ed, you can leave a comment in this post, or visit his website EdRempel.com.  You can read his other articles here.

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Ed Rempel

Ed Rempel is a Certified Financial Planner (CFP) and Certified Management Accountant (CMA) who built his practice by providing his clients solid, comprehensive financial plans and personal coaching.

Ed has written numerous articles to educate the public and his clients on his unique insights into strategies that actually work, instead of the “conventional wisdom” common in the financial industry.

Ed has trained more than 200 financial advisors and is considered the Smith Manoeuvre expert in the Toronto area. He has received accolades from Frasier Smith in his book “The Smith Manoeuvre” for customizing this strategy for hundreds of clients. His extensive experience in tax and finance has placed him in high demand. Ed’s team collaborates on each of their clients to help them create financial security and freedom.
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xmax
10 years ago

Ed,

In an earlier response you wrote – “Why would you subtract dividends and inflation? Who knows.” – and yet in your last post you write – “I find it completely distorts the story” (about inflation). I’d like to understand a) why your opinion changed between the posts and b) what story you believe is missed by looking at total real return data (inflation adjusted stock market returns with dividend reinvestment)?

Your claim that all 4 periods with no stock market growth in total real return terms “start or end with a big crash” is also incorrect – neither 1909-1924 nor 1966-1983 had such crashes however their returns were destroyed by rampant inflation (ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt) and a 10% “actual total return”, to use your terminology, is actually a loss in real terms in a 13+% inflation environment! The other two periods did not start or end with a crash either – in fact both 1928 and 1998-2001 were one of the highest gain years in history however they were destroyed by subsequent crashes – 1929 + 1930 and 2001 + 2008 respectively. And as we all remember from 1998 to present there were 2 major up and 2 major down periods – so 1998-present is an “up-and-down period with no growth”.

The main point is that the duration of a bear market and as a result whether secular bear markets exist is an academic question. What is of practical relevance is the severity of the bear market and the duration of recovery or in other words how long it would take to return your original investment which as demonstrated above amounts to 60 years of no gain in total real return terms. And that of course goes to show that the claim of stock market having positive returns in any 10 years (with the usual exception of great depression period) is certifiably wrong.

Max

Ed Rempel
10 years ago

Hi xmax,

My reference to “periods of no gain” was the actual total return of the stock market, not subtracting inflation.

I understand your logic of subtracting inflation, but I find it completely distorts the story. The long periods of time without stock market growth are not up and down periods with no growth, as the believers in secular bear markets claim.

The long periods of time with no growth in stocks are periods of time that either start or end with a big crash, which recovers quickly, but there is a short period when it is lower than an earlier peak.

For example, the 1930s was not “14 years with no growth”. It was a huge drop for 4 years form 1929-32, followed by the biggest bull market in history. From 1933–36, the market tripled with an average gain of 31.2%/year for 4 years.

This massive bull market is in the middle of the “period of no growth” claimed by many. But how can a 4-year gain of 31.2%/year be considered a bear market? That period is in the middle of the cornerstone of all claims that secular bear markets exist.

The 1966-74 period was 9 years with no gain, but it is also not just a period of no growth. It was an ordinary 7-year period with a 7%/year gain, followed by a big crash for 2 years that dipped briefly slightly before the 1965 closing value.

Right now, we have 10 years with no growth, but that is also not the story. We ended 1999 at a hugely overvalued price at the peak of the tech bubble and then had a huge crash in 2008. The low of 2008 ended up below the bubble peak of 1999. That is the real story.

Up until 2007, returns were not bad. If you include both the tech bubble growth and the crash, from 1995-2007, there was a gain of 11.3%/year. Of course it is lower if you include the crash only and not the boom by going from 2000-2007.

However, the secular bear market believers claim it is an up-and-down no-growth market, which misses the story entirely. It is a boom-and-bust story that starts at the end of a boom and ends after a crash. That’s all it is.

The 10-12%/year claimed by the investment industry is fact. That is the actual return of the various stock markets over long periods of time. The 6-7%/year figures you showed are after you subtract inflation.

The 4 periods you mentioned are now, the 1930s, and 2 periods where inflation was extremely high but stocks performed fine.

The actual stock market return in the periods you mentioned are:

1909-24 7.1%/year
1928-44 4.1%/year
1966-83 7.6%/year
1998-present 2.9%/year

My point is that secular bear markets don’t exist. They may appear to exist when you subtract inflation, or inflation and dividends, from the actual stock market return. But that all misses the story.

There has never been an “up-and-down period with no growth”. All the periods claimed either start or end with a big crash that recovers very quickly, but the low after the crash dips just below a previous boom peak.

Ed

xmax
10 years ago

Ed,

So we agree on one thing – neither the numbers you provided nor the ones I did are adjusted for both dividends and inflation, and therefore don’t paint the true picture. What needs to be discussed is total real return – inflation adjusted stock market returns with dividend reinvestment. And the crux of the matter is not how long a bear market was but rather how long are the periods when stock markets produce no gains which you asserted as: “Outside of the 1930s, the last 10 years is the only 10-year period ever with no gain.”. (I could also argue that your logic – re: stock market dividend yield exceeding inflation on average over the past century – is not applicable to the study of bear markets as dividend yields get severely inflated when share prices decline but that’s a topic for a different conversation).

Although I’m no expert, it appears total real return data is widely available – “Global Investment Return Yearbook” (http://tinyurl.com/DMS2010) and SBBI – “Stocks, Bills, Bonds and Inflation” (http://www.investorsfriend.com/asset_performance.htm) both published yearly.

This data clearly shows four periods with no gain in total real return terms since the beginning of 20th century:

– 1909 to 1924 – 15 years
– 1928 to 1944 – 16 years
– 1966 to 1983 – 17 years
– 1998 to present – 12 years and counting

So not only “no gain” periods are regular occurrences, the stock market spent almost 60 years of the last 100 going nowhere in real terms! In fact if one were to draw conclusions from the above – however unsubstantiated and premature they may be – we are in for another three to five years of “no gain”.

It is also evident that during the periods above there were investments – for example, bonds or commodities – which outperformed the stock market in real terms and sometimes significantly so. The rest of the time of course the stock market appreciated massively.

Global Investment Returns Yearbook also has a decent summary of individual countries’ annual stock market growth in real terms which stands at 6.7% for US and 5.8% for Canada – impressive numbers but much lower than 10-12% often quoted by investment industry.

Max

Ed Rempel
10 years ago

Hi Max,

The DOW stats you show exclude both dividends and inflation. The base indexes don’t include dividends and the total return index figures are harder to find, so whenever you look at stock market returns, you need to be clear whether or not they include dividends.

Dividends have averaged about 5%/year in the last 100 years (they were much higher from 1900-1950) and inflation averaged about 3.5%. So, when you subtract this 8.5%/year from the actual stock market returns, then some periods don’t look good.

Who cares about returns less dividends and less inflation?

The longest periods of no gain in US during the last 100 years were only the 14 years from 1929-42, followed by 10 years from 2000-9, followed by 9 years from 1966-74. Outside of these 3 periods, the longest period with no gain since 1871 is only 5 years.

Longer bear markets are a myth.

Ed

Ed Rempel
10 years ago

Hi Balance,

Good for you. I figured after reading Mauldin’s book that if I followed it, I could avoid bear markets – and bull markets. It was very pessimistic, which is not what we see when we look at stock market history.

We have found that having faith in the market long term pays off. It allowed us to see the “Irrational Pessimism” in early 2009, which was probably the best buying opportunity of our lifetime.

Being fearful and focusing on avoiding bear markets tends to lead to either investing mistakes or underperformance. The biggest risks in stock markets are selling at the low and failing to buy at the low.

I don’t think Mauldin has the return of the stock market anywhere in his book. There are always deductions – stock market return less dividends less inflation and less MER. Of course the returns look bad once you subtract all that.

If you do that with bonds, they look horrible as well. Let’s take the return of bonds, subtract the interest payment, inflation and the buy/sell spread, then they lost money every single year.

The periods with single-digit P/Es result from high interest rates, not the end of a secular bear market. In his book, the 3 periods in the last 100 years with single-digit P/E end in 1920, 1932 and 1981. 1932 was the bottom of the biggest crash 1929-32, but the other 2 (1920 and 1981) were both periods of extremely high interest rates.

P/E ratios generally move opposite to interest rates, since the opposite (E/P) is the yield on stocks that is compared to the yield on bonds. We think that P/Es would go to single digits during extremely high interest rates, regardless of whether it was a bull or bear market.

That’s why we think “secular bear markets” are a myth. They are periods of normal market returns that end with very high interest rates. They appear to be secular bear markets only if you subtract dividends and inflation (which is high during high interest rates).

If you don’t believe me, read the book – but don’t let it destroy your faith in the markets long term.

It is very unlikely that this period of time is a mythical “secular bear” anyway, since interest rates are low (not extremely high).

Japan is an interesting comparison. Theories of the reason for their 20-year bear market are that they are not open to trade, prop up bankrupt banks, demographic issues, or the real estate crash (as you mentioned), but we think the main reason is that it followed their super-bubble.

It went from about 300 to about 40,000 in about 10 years. To give you an idea of the size, the Japanese stock market is down for 20 years a total decline of 75%, and yet still has an average return for the last 30 years of about 10%/year. The Japanese bubble was much bigger than the NASDAQ bubble of the late 90s, so taking a long time to normalize is not that surprising.

Markets tend to have reasonably good long term returns. They get far ahead or behind that long term return sometimes, but then tend to normalize again.

Before 2008, we were not in a bubble anywhere close to that size, so we don’t see our markets doing anything like Japan.

In fact, since 2000-2009 is the only 10-year period without a gain outside of the 1930s, it appears that we are behind the trend line. The late 1990s had above average returns so we were ahead of the long term normal return. Then the 2000s had very low returns, so we are now behind the long term normal return.

This, plus our long term faith in the markets, is why we are not afraid of mythical “secular bear markets” and why we are quite optimistic now.

Ed

xmax
10 years ago

Ed,

In your analysis of stock market performance you are not adjusting your numbers for inflation either and, as you noted in criticism of Mauldin’s book, why wouldn’t you? Well, if you did (http://www.dogsofthedow.com/dow1925cpilog.htm) you would see that:

– the pre-crash peak of 1929 would not be reached until after 1955 – 26 years later rather than 14 you stated without inflation adjustment

– the period after 1966 peak which you count as 9 years without gain is actually 29 years because in inflation adjusted terms there was an almost two decade long bear market and the same peak was not reached until 1995

– current stock market level is almost flat with 1966 peak which would make it a 40+ year period with no gain when adjusted for inflation

Also, picking specific stock market periods for justifying theories about its performance is as good an exercise as snake oil marketing – you could correlate stock market performance over the last 100 years with global warming:

http://en.wikipedia.org/wiki/File:Instrumental_Temperature_Record_(NASA).svg

Max

Balance Junkie
10 years ago

I assume you are talking about Mauldin’s Bull’s Eye Investing. I read it just before I fired my financial advisor and lightened up a lot on stocks. I lost nothing in the 2008 crash.

I would encourage readers to get a copy from the library and decide for themselves whether or not they “believe in” secular bear markets. Many of the things Mauldin predicted years ago have already come to pass. If he’s right, this secular bear won’t end until PE ratios are in the single digits. It might be another decade before that happens.

We are not in a cyclical recovery right now. We are in a post-bubble credit crisis recovery. Reinhart & Rogoff’s research in their latest book “This Time Is Different” warns that the economic (and stock market) trajectory is very different following a financial crisis rather than a normal recession. (I’ll have a review of the book up on Friday.)

If you want to know what can happen to markets after a real estate bubble pops, you can take a look at a chart of the Nikkei. The Japanese real estate bubble popped about 20 years ago. Their stock market is still 70% below its 1989 peak. Property values are still depressed in spite of decades of extremely low interest rates and massive government spending.

When the Japanese bubble popped, they had very little debt and a high savings rate. When the U.S. bubble popped, they had a ton of debt and a very low savings rate.

Ed Rempel
10 years ago

Hi Clay,

I don’t know a lot about Peter Schiff, but one guy getting some predictions right does not disprove this non-correlation studies between the stock market and the economy.

Incidentally, did you notice that he predicted the economic crash, but his was wrong about the markets? He thought the US dollar would crash, but it shot up in 2008. He predicted the economy, but not the markets.

Ed

Ed Rempel
10 years ago

Hi 50plusfinance,

Fortunately for us, the stock market is not correlated to the economy. Yes, the stock market partly leads the economy (about 33%), but mostly it’s just uncorrelated.

I understand all your concerns about the economy. In think governments are bad at spending. The money is mostly just wasted.

However, none of this necessarily affects the stock market. Believe it or not, if you look back at history, our stock market has generally performed better with higher government debt – and with slower economic growth.

There are so many misperceptions about the stock market.

If you look at US government debt as a percent of GDP, it was very high during WWII, then steadily went down. It was lowest during the 70s and 80s when there were several large bear markets. Then it rose and was the highest (until recently) during the 1990s great bull market.

Ken Fisher (fund manager and Forbes writer) thinks it is because of the leverage effect. In general, companies with higher debt (up to a point) generally grow faster.

Also, many studies consistently show that the stock market generally grows faster with slow economies. So IF we go through a few years of lower growth, that might be GOOD for the stock market. (More on this in the next article.)

Ed

Ed Rempel
10 years ago

Hi Balance Junkie,

The markets being up 70-75% of the time holds for the last 200 years. It also holds in nearly every country. It is not a bull market phenomenon. It is a general stock market phenomenon.

I read a book by Mauldin talking about secular bear markets. We think they are a myth. When are they supposed to have happened???

We have the S&P500 data since 1871. Outside of the 1930s, the last 10 years is the only 10-year period ever with no gain.

When was there a secular bear?

In addition, the longer periods of no growth do not have the pattern you mentioned (other than perhaps 1929-42). They were periods that started or ended with a huge crash.

The 3 longest periods of no gain and pattern are:

1929-42: 14 years with no gain. Started with a 4-year crash from 1929-32 followed by a massive recovery from 1933-42

1999-2008: 10 years with no growth. There was a gain of 3.6% from 1999-2007. The 10-year period with no gain was just because it ended with a big crash in 2008.

1966-74: 9 years with no gain. There was a gain of 7%/year from 1077-72. The 9-year period with no gain was just because it ended with a big crash in 1973-74.

After that, the next longest period with no growth was 5 years, which happened a few times, all with minor losses only. The worst one was 1873-77 with a loss of 1.8%/year.

So, when was there a secular bear????

The book by Mauldin had several secular bear markets where the markets made nothing – if you subtract dividends and inflation. (Why would you subtract dividends and inflation? Who knows.) The “secular bear markets” were all periods of time that ended with high interest rates, which usually means P/E’s are lower. If you take the times that end with high interest rates and then subtract inflation and dividends from the stock market return, there is no gain. All that proves nothing.

We think that secular bear markets are a myth.

We are at the end of the 2nd longest period of time ever with no gain and there is pessimism everywhere. That’s what the start of great bull markets look like! For example, the last great bull market was 1983-99, which started in the middle of a big recession with pessimism everywhere.

Ed