When Stocks and the Economy Diverge

If I told you one year ago that a global pandemic would shut down the U.S. economy, unemployment would jump to 15%, GDP would fall by about 50%, oil prices would fall to zero, and yet the stock market would be higher than it was back then, you’d say I was crazy. Yet that’s where we are. So why the big disconnect between the stock market and the economy?

Here’s an article that discusses this divergence. It reminds us that markets are forward-looking in nature, and while they don’t totally ignore current economic conditions, markets focus on future expectations for economic growth and the potential impact on corporate profits.

In particular, the article plots 90 years of GDP growth and shows how stock market returns have been more correlated with GDP one year out than in the same year. This suggests that while the stock market isn’t always prescient, as we’ve seen in instances like the global financial crisis, it does a pretty good job of anticipating future economic growth and corporate profits.

The article also helps allay another concern investors commonly have, which is whether there will be fallout from the trillions of dollars in fiscal stimulus that will be added to our nation’s debt. When comparing high-debt and low-debt countries historically, stock market returns have been slightly higher for high-debt countries. This suggests that markets tend to do a good job at pricing in the potential impact of high indebtedness, at least in the short term, and that a high level of debt is not necessarily a bad thing for stocks.

Like many, I was surprised by the stock market’s performance the past couple months, as it’s hard to imagine that economic conditions will recover to the levels that prices suggest. I also worry about the long term implications of piling on so much government debt. This may indeed be one of those times that the market gets things wrong, but I wouldn’t bet on it. Given their track record and ability to process vast sets of economic data and expectations for the future, capital markets have been the best economic indicators of them all.