Why the Economy Most Certainly Is Relevant to Investing

| About: SPDR S&P (SPY)
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I hadn’t planned on posting today since I’m supposed to be on vacation. But I saw an article last week that I just had to comment on, so I decided to put up a little Friday Food for Thought today. The article in question claimed to explain Why the Economy is Not Relevant to Investing.

Some of you will read that title and immediately decide that the premise is ridiculous. Still, if you’re as curious as I am, it’s just ridiculous enough to make you want to read what the author has to say. I’ve written before that economic information is like a financial weather forecast and I’ve done my best to articulate Why You Should Care about Economics. This article didn’t change my opinion on any of these issues.

My aim is not to discredit the author here. In fact, he is a CFP (Certified Financial Planner) and CFA (Certified Financial Accountant) and is therefore theoretically much more qualified than I to discuss these matters. I just want to point out the other side of the debate. After that, it is (as always) up to you to decide where you stand.

It’s the Economy, Stupid

This catch phrase from U.S. President Bill Clinton’s 1992 campaign has bubbled up in the headlines again as elections approach south of the border. Many believe that the state of the economy will determine which party is more successful this November. But does the economy have anything to do with stock market performance?

I’ll quote some of the arguments presented in the article in question and offer a brief rebuttal for each:

  • “most investors buy and sell investments at the wrong times . . . because they base their decision on a mainly irrelevant factor – their outlook for the economy.”: I actually agree that many investors buy and sell at the wrong times, but I don’t think it’s because they’re using the economy as a guide. It’s usually because they are not following a robust trading system that includes a disciplined exit strategy – or because they are listening to people who tell them that buy and hold is the only intelligent investment strategy.
  • Next, the author explains that “there are 2 main reasons why the economy is not really relevant to investing”:

1. “The stock market is the head and the economy is the tail.” The idea here is that “the stock market forecasts the economy, not the other way around.” On the contrary, history is replete with examples where the markets have gotten it wrong. Markets rallied hard from 2003 to 2007 even as the U.S. housing market was beginning to implode. Perhaps it could be argued that the bond market got it right, but the stock market was way off the mark. It didn’t correct until the financial system became crippled under the weight of loans supported by fantasies and fraud.

2. “Expectations of how the economy will perform are already built into the price of stocks.” Again, that may or may not be the case at any given moment, but it is not always, or even often, true. Further, “expectations” and reality often diverge quite radically as we have seen repeatedly over the course of history. Was the 2007 stock market pricing in the calamity that befell the economy in 2008?

  • ‘A “double-dip recession” probably won’t happen this year. How do I know? Because the stock market went up last year!’ Setting aside the potential conflicts presented by someone who claims the economy is irrelevant making economic predictions, I can offer another reason why a double-dip recession won’t happen this year: The first recession never ended. The “recovery” that we’ve seen over the past year or two was the result of unprecedented government interventions whose effects are now fizzling. The stock market went up in 2007 too. The economy sank into a near-depression in 2008.
  • “You can predict the stock market more accurately by simply always predicting it will go up!” Seriously? Here’s where the number torture comes in. The author says that “in the last 25 years, the Canadian and global stock markets have been up 76% of calendar years and the U.S. market has been up 72% of years.” The key here is to realize that he’s talking about the performance of calendar years in isolation. So any given up year may have been preceded by a year that was down enough that the market still does not recover its losses in the up year. That’s how the market can have very large moves over a decade and still end up nowhere at the end of it. (That’s called a secular bear market and that’s what we’ve got on our hands right now.)

David Rosenberg recently pointed out some of the reasons this type of thinking won’t work in today’s investing environment:

What the bulls still refuse to see is that we are in an entirely new paradigm and that the old rules of thumb are rarely, or ever, going to be able to be relied upon, as was the case in the credit-expansion days of yore. There is simply too much debt overhanging the U.S. household balance sheet, the largest balance sheet on the planet. Despite the deleveraging efforts to date, the process of balance-sheet repair is still in its infancy.

I will grant that the stock market and the economy rarely move in lockstep. Economic information is definitely not the only information investors need to be successful, but to exclude it altogether is just foolhardy. I’ll leave it up to you to decide whether you want to trust your money to a professional adviser who tells you to ignore the economy based on arguments that are specious at best.

Disclosure: No positions