The Stock Market Versus the Economy

Over the last two weeks, the main winners in the gyrations of the stock market may have been antacid companies. When the week opens with an 1,100-point drop in the Dow within five minutes, it's a safe bet the rest of the week will be stomach-churning, regardless of economic fundamentals.

The Dow, NASDAQ, and S&P 500 all joined in, taking investors on a wild ride but rebounding to close slightly up for the week. Following successive daily drops of 587 and 206 points, the Dow rose 619 points and 369 points in the next two days for the largest two-day point gain ever. A slightly down Friday left the Dow up for the week by around 1%. The NASDAQ reversed an almost 9% drop to end up ahead 2.6% for the week, and the S&P 500 recovered from a drop of over 5% to finish the week at just under a 1% gain.

All this turbulence comes at a time when signs point to increasing strength in the US economy. If the US economy really is getting stronger, why are US stock markets so volatile? The broad answer: the economy is much more than the stock market, and vice versa. It's not uncommon for the stock market to lead, lag, or head in the opposite direction from the broader economy.

Connected, Yet Distinct
One thing the stock market and broader economy do have in common is a mixture of economic fundamentals and psychology.

The stock market is a measure of the perceived value of companies, as it reflects what people are willing to pay for their shares at any given point in time. Investors evaluate price using objective criteria, such as revenue/earnings, sales, expense, cash flow, assets, and profit, while other measures are subjective and based in the future. What are growth and earnings predicted to be? Is market share expected to increase or decrease?

Throw in herd mentality and the occasional panic, and the stock market is at least as much about the psychology of the future as it is the economic fundamentals of the present.

Conversely, the economy boils down to basic principles of supply and demand. Is there a sufficient demand for manufactured goods and services to promote growth in manufacturing and service sectors? Do consumers have enough funds available to pay for them? What external factors are acting on these forces (value of the dollar, central bank policies, actions of trading partners, etc.)?

The psychology of the economy comes into play at both the consumer level and financial level. Even if they have the money, do consumers feel confident enough about their job situation, total debt, and current wages to make discretionary purchases? On the central bank and legislative side, do officials feel the need to raise or lower interest rates, print more money, or create spending stimulus to "prime the pump?"

The best way to sum up the connection is that the psychology of the market reacts to the psychology of the economy, with underlying objective facts that either strengthen or weaken the current arguments. The disconnect is that the market is less concerned with fundamental supply and demand, and more so with future expectations.

That concept brings us to the past week, where stocks were falling broadly, as some investors let psychological factors override economic fundamentals and pulled out of all stocks instead of evaluating individual stock performances and the underlying fundamentals. During 2008, there were fundamental issues within the US economy that drove a stock market plunge while suggesting continued trouble in the near-term future. That's not the case in 2015.

US Economy Gains Momentum
Economic news has been relatively bright for the US lately. Second-quarter GDP was adjusted upward from 2.3% to a 3.7% growth, and the first quarter pulled out of the red to show a 0.6% growth. Second quarter growth was broad-based and includes business investments and spending from both consumers and government. Consumer spending was revised up to 3.1% in the second quarter, and the Consumer Confidence Index rebounded sharply to 101.5 in August from a reading of 91 in July.

The stubborn housing market has finally begun to show improvement as well. Both pending and existing home sales rose in July. Spending on home building/improvements in the second quarter improved by 7.8%, on top of a 10.1% first quarter gain.

Second-quarter corporate earnings were mixed, but still above estimates for many large companies. The recent drop brought forward price-to-earnings (P/E) ratios down to a reasonable 16-17 range for the Dow Industrials and the S&P 500. In essence, the US economy is still sound and growing, and should continue to grow -- although not as fast as some would like. The strong dollar and reduced worldwide demand should keep growth slow in the short term.

Meanwhile, from the stock market perspective, a few distorting factors remain. By keeping interest rates at historic lows for several years, the Fed has driven money toward stocks, as they are the only refuge for decent returns. Once the Fed actually does raise rates, the stock market should return to an emphasis on fundamentals -- i.e., less psychology and more economics.

Concern about China will continue to distort US equity markets as well, although it's less about the state of the Chinese economy than it is uncertainty about how the Chinese government will react, and how their actions might snowball across the global economy. Expect the market to continue to be volatile while the economy chugs along at a slower, steadier growth pace within that volatility.

The Takeaway

You cannot ignore psychological factors when deciding what to do with your portfolio, but don't let them overwhelm the economic fundamentals. Investors who remained calm through the fall and successfully identified buying bargains (and losing stocks) made money. Those who engaged in panic selling across the board without regard for long-term value lost money. That was true for both the long-term investors and speculators attempting to make money on individual stocks.

Your decision to adjust exposure to individual stocks or entire sectors should be based on your age with respect to retirement, your risk tolerance, and your financial needs -- not the momentary variations of the market. If you can't handle market fluctuations like last week's, reduce your exposure to stocks accordingly -- but adjust your retirement expectations as well. It's better to be happy with a more frugal lifestyle than to be a nervous wreck trying to maintain a higher one.

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