The economy is not the stock market

Website design By BotEap.comSeveral days ago, the Commerce Department reported that factory orders for May had risen 2.9 percent. This was well covered by ‘the press’, as it was going to be a positive influence on ‘the market’ (yes, the quotes are intentional… you’ll see why). The enthusiasm was understandable: the $394 billion in manufacturing orders is the highest level seen since the current calculation method was adopted. While being skeptical may be wise, the number was (and is) a clue that the economy is on solid footing. However, too often there is a disconnect between what ‘should’ be the result of economic data and what actually happens. The economy is not the market. Investors cannot buy shares on factory orders…they can only buy (or sell) shares. Regardless of how strong or weak the economy is, one only makes money by buying low and selling high. So with that, we put together a study of some of the economic indicators that are treated as if they affect stocks, but actually don’t.

Website design By BotEap.comGross domestic product

Website design By BotEap.comThe chart below shows a monthly S&P 500 versus a quarterly Gross Domestic Product growth number. Keep in mind that we are comparing apples to oranges, at least to a small degree. The S&P index should generally rise, while the percentage growth rate of GDP should remain between 0 and 5 percent. In other words, the two will not move in tandem. What we are trying to illustrate is the connection between good and bad economic data and the stock market.

Website design By BotEap.comTake a look at the chart first, then read our thoughts immediately below that. By the way, gross GDP figures are represented by the thin blue line. It’s a bit erratic, so to smooth it out, we’ve applied a 4-period (1-year) moving average of the quarterly GDP figure – that’s the red line.

Website design By BotEap.comS&P 500 (monthly) versus change in Gross Domestic Product (quarterly) []

Website design By BotEap.comGenerally speaking, the GDP number was a pretty lousy tool if used to forecast stock market growth. In area 1, we see a big economic contraction in the early 1990s. We saw the S&P 500 retrace about 50 points during that period, even though the drop actually happened before the GDP news came out. Interestingly, that ‘horrible’ GDP number led to a full market recovery, and then another 50 point rally before the uptrend was tested. In area 2, a GDP that exceeded 6 percent in late 1999 or early 2000 would usher in the new era of stock market gains, right? Mistaken! Stocks flattened a few days later…and stayed flat for over a year. In area 3, the fallout from the bear market meant a negative growth rate at the end of 2001. That could persist for years, right? Wrong again. The market bottomed out right after that, and we are well away from the lows that occurred in the shadow of that economic contraction.

Website design By BotEap.comThe point is that just because the media says something doesn’t mean it’s true. It can be important for a few minutes, which is great for short-term trading. But it would be inaccurate to say that it even matters in terms of days, and it certainly can’t matter for long-term charts. If anything, the GDP figure could be used as a contrarian indicator… at least when it reaches its extremes. That’s why more and more people are ditching traditional logic when it comes to their wallets. Paying attention solely to the charts is not without its flaws, but technical analysis would have taken it out of the market in early 2000 and back into the market in 2003. The latest economic indicator (GDP) would have been well behind the market trend in most cases.

Website design By BotEap.comUnemployment

Website design By BotEap.comLet’s look at another well-covered economic indicator…unemployment. These data are published monthly, instead of quarterly. But like the GDP data, it is a percentage that will fluctuate (between 3 and 8). Once again, we are not going to look for a market that reflects the unemployment number. We just want to see if there is a correlation between employment and the stock market. As above, the S&P 500 appears on top, while the unemployment rate is in blue. Take a look, then read on below for our thoughts here.

Website design By BotEap.comS&P 500 (Monthly) vs. Unemployment Rate (Monthly) []

Website design By BotEap.comDo you see something familiar? Employment was strongest in area 2, just before stocks plunged. Employment was at its worst in recent times in area 3, just as the market ended the bear market. I highlighted a range of high and low unemployment in area 1, just because neither seemed to affect the market during that period. Like the GDP figure, the unemployment data is almost more apt to be a contrarian indicator. However, there is one thing worth mentioning that is evident from this chart. While unemployment rates at the “extreme” ends of the spectrum were often a sign of reversals, there is a good correlation between the direction of the unemployment line and the direction of the market. The two typically move in opposite directions, regardless of the current level of unemployment. In that sense, logic has at least a small role.

Website design By BotEap.comBottom line

Website design By BotEap.comYou may be wondering why all the talk about economic data in the first place. The answer is simply to highlight the reality that the economy is not the market. Too many investors assume that there is some kind of cause and effect relationship between one and the other. There is a relationship, but it is not usually the one that seems most reasonable. Hopefully the charts above have helped clarify that point. This is why we focus so much on charts and are increasingly hesitant to incorporate economic data in the traditional way. Just something to think about the next time you’re tempted to respond to economic news.

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