* The author has experience in Corporate Finance and Special Situations gained in an American investment bank and for three multinationals. Lives and works in New York. He is the founder of Investirecomeimigliori.com
The history of the stock exchange has always been marked by Booms and Busts. If you then study the markets, you will easily find articles and books that talk about the collapse of 1929, 1989, 1999, 2008 up to the last, most recent, of March 2020. Lately, this is a much discussed topic. I am often asked for the because of the disparity between the market and the economy. How can a market go up while almost half of the American population is out of work? The answer is that the market and the economy are not the same and in this article I will explain some of the reasons that create this disparity.
What is Economy?
Economy, explained very simply, is the production and consumption of products and services. The economy includes individuals, companies and governments that interact with each other, creating supply and demand.
What is the stock exchange?
The stock exchange is nothing but a exchange, where shares of public companies can be issued, bought and sold. Positions can be made in individual companies or via ETFs. In practice, the stock exchange is an intermediary who helps us obtain property in public companies.
Economic data look to the past, the stock market looks to future projections
Economic data are simply historical data of what has happened in the past. In reverse, the market is based on future projections. Or better, tries to anticipate economic news, the monetary policies of central banks and the fiscal policies of governments. For this reason, the movement of short-term markets does not reflect the real economy. So while there are these short-term differences, in the long run usually both the market and economies have a greater correlation.
What affects the markets?
GDP does not have an immediate effect on the market. Positive or negative expectations instead yes. An investor is interested in future expectations of interest rates. The market is interested in whether the Federal Reserve Chairman intends to raise or lower interest rates in the next meeting. The same goes for titles. What matters to the market is what they call “earning guidance” or the expectation of earnings. In general, investors look to expectations on EPS (earning per share). On your brokerage account you will find the analysts’ rating, their analysis on the stock. This is nothing more than their expectation based on earning guidance.
The rate of change
Now that we have covered the concept of market expectations, we can deepen it by introducing the rate of change. A concept that I learned in school, but also applicable in markets. The movement of the markets is not only based on a growing or falling economy. But it is mainly based on the rate of change. To be more precise, is the rate of change of economic growth increasing or decreasing? The market wants to understand if things will improve but above all at what speed.
THE Long-term markets and economies tend to be related. In times like those where we are now, at the apex of a cycle, the correlation is less evident. The reasons are different and some of them I explained in this article. Predicting where the market will go tomorrow is a dangerous game, in which those who do it for work are also burned. For this reason, instead of worrying about erratic market movements, or about correlation with the economy, the average saver should focus on creating a long-term investment strategy. A strategy that gives him the opportunity to capitalize, but also to protect capital during a collapse like that of March 2020.
As Peter Lynch, famous manager of the Fidelity Magellan Fund reminds us “investors have lost more money trying to anticipate a market correction than in the corrections themselves”.