Throughout the year, government agencies and other organizations release data intended to give us a sense of how the economy is faring. Many investors sift through these statistics—which measure things such as gross domestic product (GDP) growth, unemployment and inflation—to get a sense of the economy’s health and divine possible investment trends.
The trouble is that there is a lot of data out there, but not all of it is useful in gauging stock market behavior. While sudden changes in economic conditions can lead to a short-term reaction by the stock market, the effect of economic growth on share prices fades over longer periods, providing little insight into the future direction of the market. Ned Davis Research has found that since 1948, changes in U.S. GDP explain less than 2% of the year-over-year changes in U.S. stock prices on average.
Let’s take a closer look at some economic snapshots and how investors might use them to think strategically about shifting conditions.
Economic growth and markets
It seems reasonable to assume that economic growth helps drive stock markets. After all, a growing economy should generate higher corporate profits, which you would expect to boost equity returns.
However, this is not necessarily the case. Researchers have found there is essentially no correlation between U.S. equity returns and per capita changes in real U.S. GDP. If anything, stock market returns are more closely related to economic growth in the following year.1
This is likely because markets anticipate changes in economic conditions and the potential future effect on corporate earnings—meaning investors’ ideas about the future are generally reflected in share prices today. In fact, the predictive power of markets is why the S&P 500® Index is one of the 10 components of the Leading Economic Index® (LEI) compiled by the Conference Board, a non-profit business and research association.
“If you’re thinking about the relationship between the economy and the stock market and using one to forecast the other, you’re better off using the stock market to forecast the economy than the other way around,” says Liz Ann Sonders, Chief Investment Strategist at Charles Schwab & Co., Inc.
This doesn’t mean the market is always right, but if you hold off on investing until the economy is growing strongly, you will likely miss some of the best market gains.
Predicting the future
It’s simply not possible to know how the economy will perform in the future, and there are times when economic conditions can exert a powerful influence on markets. For example, there is no way to predict when an unexpected spot of weakness in the economy might cause a sudden short-term swoon in the stock market.
So, while there is little long-term value in basing your investing plans on the pace of growth, in some cases signals about the health of the economy might prepare you for short-term bouts of volatility.
Liz Ann says the LEI can occasionally deliver useful signals to investors about the stock market. While the index’s individual components might not mean much on their own, there are times when they all start moving in tandem and markets sometimes follow.
“When they all start moving up, that’s usually a pretty powerful environment for the stock market,” Liz Ann says. Conversely, “when they start to diverge—when you see five, six or seven of the leading indicators start to roll over, while the market has been doing well—that’s worrying.”
The yield spread component of the LEI, which measures the difference between the 10-year Treasury rate and the federal funds rate, has had the best track record of the bunch when it comes to signaling a recession. Historically, when the 10-year rate slipped beneath the federal funds rate—what economists call an “inverted yield curve”—a recession has almost always followed.
“Every bear market in history has been preceded by an inverted yield curve,” Liz Ann says.
Planning and rebalancing
Rather than focusing too much on indicators, Liz Ann urges investors to formulate and adhere to a long-term investing plan that accounts for their time horizon and tolerance for risk. Regularly rebalancing to keep your investments in line with your target asset allocation is a disciplined way to buy low and sell high, she says.
“The best advice we try to give investors is: Don’t try to forecast the market because it’s impossible,” Liz Ann says. “Any one data point can move markets in the short term, but over the long term they have much less influence. Planning and rebalancing minimizes the common mistakes driven by crowd psychology, and is much more conducive to achieving your long-term investing objectives.”
1Elroy Dimson, Paul Marsh and Mike Staunton, “Credit Suisse Global Investment Returns Yearbook 2014,” 2/2014
Each month, the Conference Board publishes its Leading Economic Index (LEI) reading for the economy. The LEI score is based on 10 components and is intended to pick up on turning points in the economy. The table below takes a broad look at what is covered and what it might mean for the economy.