“The stock market’s link to the economy can be as thin as tissue paper,” reported The Wall Street Journal this morning. Sounds unprecedented, right? But is it, really? Let’s explore.
GDP vs. S&P 500 Since 1947
Stocks represent ownership in companies, and the connection between a company’s health and stock prices is strong, over time. Of course, companies are impacted by the economic environment, but perhaps less than the quote above would have you believe.
To learn more, we looked at quarterly GDP growth versus quarterly S&P 500 over the last 74 years. Since 1947, the correlation between quarterly GDP growth and quarterly stock returns is … 0.06. Quick reminder: the strongest positive correlation would be 1.0, while negative 1.0 would show the strongest negative correlations. A correlation of zero simply means there is no correlation, so a correlation of 0.06 is basically non-existent. (Among analysts, it’s known as being Irish, as in “Meet my new friend, Point O’Six!”)
Stock Returns Over Economic Cycles
Now, there is lag we can account for, as GDP data isn’t released until 4 to 6 weeks after the quarter ends. Accounting for that lag reduced the correlation to negative 0.01.
What if we extended the time period we analyzed from 1 quarter to 7 years, allowing for a typical economic cycle? Perhaps that introduces a better connection between stocks and economic growth. Sorry, the correlation with this adjustment is a whopping 0.07.
Is there really no relationship between stocks returns and economic cycles? No, not really. If I sliced the data differently, looking explicitly at recessions vs. expansions, you would be able to see the impact of recessions on stock prices. But it’s still not a clean as one might think. Why? Because stocks have been and remain forward looking, and this makes perfect sense.
The classic formula for valuing a stock (or any asset) is the present value of future cash flows. So, the reason stocks have been rallying since March while COVID-19 remains a current threat is that stocks are looking into the future. And with several vaccines on the way, stock prices are clearly expecting a return to a fully functioning economy. This is not a new phenomenon. It’s how stock pricing works, which is why the S&P 500 is one of the ten components of the Conference Board’s Index of Leading Economic Indicators (LEI).
Bottom Line: Interested in investing in GDP? Explore some GDP futures contracts. Interested in investing in equity growth for the long run? Then a diversified exposure to stocks is your answer.
Thoughts or feedback? Let’s talk.