The economy is down - why is the market up?

As of this writing in June 2020, things are...not the best they've ever been. COVID-19 cases are experiencing a sharp uptick as states have started to reopen. The US is looking at record unemployment. GDP is negative for the first time since 2014. Large, established companies such as Hertz have gone bankrupt. Protests have rocked every state.

So why is the S&P500 up from where it was this time last year? Is the market nuts? Is this some kind of weird bubble, a disconnect from reality that will doom our retirement portfolios?

Those of you with employer stock may be familiar with a similar conversation. How many times has your company released record earnings, only to find that your stock price went down? Or released worse earnings than guidance, and seen the stock price go up? What is going on?

The answer is: yes, there is a disconnect from reality, but probably not in the way that you think.

The relationship between GDP and market returns...or lack thereof

The fine researchers over at Dimensional Fund Advisors recently published an article that goes into this phenomenon in interesting ways. In this article, they present a graph of GDP versus the US "equity premium" -- the additional return you get by owning stocks rather than bonds, which is a measure of what we would call "market returns". Take a look, and see if you can spot the pattern:

See it? No? Well, that's unsurprising: there isn't one! So stock prices really are disconnected from reality, then?

Well, kind of. Take a look at this graph of the equity premium versus the next year's GDP:

Annual GDP growth rates obtained from the US Bureau of Economic Analysis. GDP growth numbers are adjusted to 2012 USD terms to remove the effects of inflation. Annual US equity premium is return difference between the Fama/French Total US Market Research Index and One-Month US Treasury Bill. Equity premium data provided by Ken French, available at mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html. Eugene Fama and Ken French are members of the Board of Directors of the general partner of, and provide consulting services to, Dimensional Fund Advisors LP. “One-Month Treasury Bills” is the IA SBBI US 30 Day TBill TR USD, provided by Ibbotson Associates via Morningstar Direct.

There's a distinct (but not universal, because always in motion is the future) trend of "up and to the right" -- the higher the stock price, the higher the following year's GDP. Which means that stock prices aren't based on what's happening now; rather, they're based on what will happen in the future.

So, that weird disconnect you see between what's happening and what the stock market is doing? That's because the market cares much less about the present than it does about the future. As soon as the future starts to crystallize, the stock market starts moving. So if (for example) the Fed says that it's going to take action to boost the economy, buying corporate bonds, lowering interest rates, and so on, then market prices will immediately react on that news, rather than waiting until the action is taken. As soon as the Congressional Budget Office releases a prediction that GDP will be positive for 2021, market prices react in 2020.

Now, is the market always right? Of course not. But it's really, really efficient. Betting against it can be profitable if you get lucky, but the long term money is on the casino, not the gambler.

Sidebar: is this fair?

Some of you may be thinking, "Now, hold on. If your wealth comes from your investments, then it seems like you're in a much better position than if your wealth comes from your job. If the market responds at the speed of information, but jobs -- hiring freezes, raises, etc. -- respond at the speed of reality, then situations like COVID-19 could wreck workers but not really be a blip on the radar of investors!"

You're not wrong. I mean, sure, I'd be remiss if I didn't point out that the stock market started its COVID plunge in February of 2020, several weeks before the unemployment nastiness showed up -- investors felt the pain before workers did. But in general, the downward spiral caused by extended unemployment is going to have a much greater effect on a laborer than the temporary pain that a market downturn will cause an investor. This is one of many reasons why, if left to its own devices, the gap between rich and poor increases over time.

As for addressing that issue, well. That's a discussion for another time.

But what about debt?

Sidebar aside, some of you may be asking, "But the US is printing money! How can the market possibly think that this is sustainable? Won't the debt eventually cause the markets to come crashing down?"

And that's a reasonable hypothesis. At the very least, one might expect that the market would price in the cost of debt service when calculating expected returns, lowering them accordingly as debt rates go up. That DFA article I mentioned takes a look at this, too. Specifically, they took a look at countries with an above-median debt ratio versus ones with a below-median debt ratio, and compared the average equity premium between the two. One would expect that below-median debt would correlate with higher returns, right? Well, take a look.

All returns in USD. Countries are sorted at the beginning of each year. High-Debt and Low-Debt refer to countries above and below the median debt, respectively. Debt is general government debt and central government debt. Source: The International Monetary Fund. Equity market returns represented by MSCI country indices. Dimensional calculations from Bloomberg and MSCI data. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.

Turns out, not so much. And in fact, the t-statistic for each of these tables is well below 2.0, which means that the difference is statistically insignificant; there's basically no correlation between above-average v. below-average debt and equity returns. (And if you're wondering where the US stands, here's some public debt data on various countries. Not the lowest by a long shot, but not the worst, either.)

So...what do we do?

Alright, so we've established that you can't correlate the current state of the economy with market prices; today's GDP at best correlates with last year's market returns, and debt levels don't seem to correlate with market returns at all. So...that means that we should just throw up our hands and give up?

Well, it depends on what you mean by "give up". If you mean "give up trying to figure out where the market is going", then -- yes, actually. I mean, if you want to speculate with 5% of your portfolio in order to scratch your gambling itch, then that's your business. But otherwise, why not stop worrying about the things that you can't control or predict, and instead focus on the things you can? Make sure you have enough cash on hand to weather an emergency. Make sure your portfolio fits your risk tolerance and capacity, so that if the market tanks it won't break your plan or cause you to lose sleep. Optimize your investments systematically. And once the system is set up, focus on what can lead to serious wealth.

Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.