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The Difference Between The Stock Market And The Economy

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00:00   |   Apr 05, 2019

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The Difference Between The Stock Market And The Economy
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  • As an investor you will encounter days
  • where the Dow is up 1000 points.
  • We have the Dow intraday...
  • the biggest points gain ever.
  • One thousand and thirty six.
  • You will also encounter days where the
  • Dow was down 800 points.
  • The Dow Jones Industrial Average tumbled by 831 points, that's 3.2%.
  • The Dow dropping more than 650 points
  • the largest December decline since the Great Depression.
  • People ask all the time when they see a
  • huge move in the market.
  • Does this mean I'm going to lose my job? Does this mean I'm about to have the best year I've ever had in my business?
  • What is the relationship between what stock prices are doing
  • each day versus what's happening on
  • Main Street, what's happening in the \real economy?
  • I like to use an analogy of a man
  • walking the dog across a park.
  • Try to picture that.
  • You got a guy.
  • He's got a leash.
  • There's a dog on the other end of it.
  • They're walking in the same direction.
  • However, if you observe the way the man
  • crosses the park. His gait. His stride.
  • it's fairly straightforward.
  • Very few deviations kind of like an economic trend.
  • Then when you think about what the dog is doing. The dog is running around like a lunatic.
  • The dog is barking at people.
  • It darts to the left.
  • It darts to the right.
  • It strains on the leash.
  • Maybe it chases a squirrel, barks again. The thing with the dog is that's the stock market.
  • The man walking the dog is the economy.
  • So they both end up in the same place.
  • They're both sort of walking in the
  • same direction most of the time.
  • There's a lot less deviation in how the
  • man walks than how the dog walks and I
  • think when you consider the stock
  • market barking jumping back and forth
  • straining at its leash that's a really
  • good way to control your own emotions and to say to yourself "Ok the economy
  • is probably not fluctuating to the same extent that the dog is or the stock market is."
  • So we use that analogy all the time.
  • Here's the S&P 500 plotted against GDP growth. You'll notice that in any one
  • given year you can have some divergence between the two.
  • Look at 2009 real GDP fell 2.5%.
  • Stock market meanwhile went up 26% that year.
  • The 1970s all for some examples of that
  • 1975 real GDP meaning inflation
  • adjusted economic growth fell 0.2%. Stock market was up almost 40% that year.
  • Again, they're related kind of going in the same direction over long stretches.
  • But in any one calendar year, they don't necessarily have to look alike at all.
  • Now here's something really important.
  • All things being equal, even if I gave you next year's economic information,
  • what would you do with it?
  • You certainly would know what the reaction of the stock market or the bond market are going to be.
  • You could have any economic outcome and have any stock market reaction to it.
  • Up to an including a terrible reaction a great reaction or no reaction.
  • Now what about the reverse.
  • Do stocks tell us what the economy is about to do.
  • The answer is very unsatisfying
  • sometimes. So stocks are thought of as a leading indicator for the economy but
  • a lot of times they get things wrong or stock market prices overreact.
  • Good evening, The stock market went into a freefall losing more in one day
  • than it did on Black Tuesday in 1929.
  • I always point out in 1987. That was a 23% percent crash within one day. The economy didn't even notice.
  • I don't think anyone should panic because all the economic indicators are solid.
  • But we've had examples where the stock market has been an accurate predictor of what would happen with the economy
  • and maybe the best example would be the 2000 dotcom crash the worst day ever on Wall Street.
  • All the major indices are now down for the year.
  • We had an incredible economy from 1982
  • until the year 2000 and then all of a sudden the stock market was saying
  • things have gotten way too hot started to come down got worse spread from
  • technology stocks into mainstream stocks and within a year we were in a fairly long recession.
  • So there are times where the market is giving you that signal.
  • Then there are times where the market is giving you a signal that doesn't end up leading to anything.
  • And being able to tell the difference between the two is nearly impossible especially in real time.
  • So whenever you hear someone make a stock market forecast based on how the economy is currently doing
  • or how they think the economy will be doing, it's very important for you to remember
  • how many other variables impact stock prices and the stock market.
  • Everything from geopolitics, natural disasters, interest rates, tax rates.
  • Whether or not there is any kind of fiscal program that takes place. Whether
  • or not there is any kind of change in the law for things like buybacks or dividends.
  • There are so many things that can happen that are not GDP that
  • will affect the prices of stocks that it's nearly impossible to point to any one metric whether it's jobless claims
  • or economic growth or overseas economic
  • growth and say this plus this equals that. If it were that simple we would all be rich.
  • Everyone would know exactly how to invest and 2018 offers us a perfect example.
  • Exciting! Live! Breaking news!
  • The American economy growing at its strongest pace in four years Payrolls rose by 250,000 jobs.
  • So here's a year where you've got solid GDP growth you've got the unemployment
  • rate steadily dropping month after month millions of jobs being added
  • really no negative issues with the economy whatsoever.
  • All of the ingredients that you can ask for to say this is a good economy this is a good environment for business.
  • Stock market went down 5%.
  • You said yourself well wait a minute.
  • If you had told me at the end of 2017
  • that I would have all these great things I wouldn't have expected a down 5% year for stocks and that goes
  • to show you how many other ingredients there are that affect the outcome.
  • By the way expectations are one of the
  • most important ingredients we came into 2018 already expecting all that great
  • news. So stocks have been priced for the best we got the best and guess what
  • they were already worried about 2019.
  • The other thing I would mention if you think about the dog analogy walking through the park,
  • a lot of stock market participants expect the Federal Reserve
  • to watch the dog and to some extent the dog is worth watching.
  • But I do think it's important to
  • realize Jerome Powell the Federal Reserve chairman his real job is to focus on the man walking the dog.
  • And so you may see a lot of volatility
  • in the markets that doesn't necessarily get a reaction from the people who set monetary policy.

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Description

Each day, investors are treated to news about the economy and information about how the stock market has done recently. It can be very difficult to process what’s going on because at any given moment in time, there may be very little correlation between how things are going in the real world and how prices are acting on Wall Street.

The noted fund manager and author Ralph Wagner once described the relationship between the economy and the stock market thusly:

“There’s an excitable dog on a very long leash in New York City, darting randomly in every direction. The dog’s owner is walking from Columbus Circle, through Central Park, to the Metropolitan Museum. At any one moment, there is no predicting which way the pooch will lurch.”

“But in the long run, you know he’s heading northeast at an average speed of three miles per hour. What is astonishing is that almost all of the dog watchers, big and small, seem to have their eye on the dog, and not the owner.”

I use this analogy all the time to help people understand how the economy and stock market play off of each other. One of the hardest things to do as an investor is to entertain two opposing thoughts in our minds at once, and find a way to keep them despite the cognitive dissonance this can produce.

One of the most ironic aspects of investing is that the greatest gains lie ahead at times when things are bad, but not quite as bad as everyone suspects, and slowly, almost imperceptibly getting better. This is the moment when assets are selling at discounted values and the opportunities are laying at our feet, there for the taking.

Conversely, the worst time to invest is once everyone agrees that the environment is terrific and that the gains will continue as far as the eye can see. It is at this moment we find ourselves paying up for assets and competing with lots of other buyers.

But most of the time, neither the economy nor the stock market is as good as it could get, or as bad as it could get. Typically, the economy trudges along a straight path for years at a time and it’s the stock market that is easily excitable, ripping to and fro based on the latest information to hit the tape. Over longer periods of time, we do see a correlation between stocks and the economy, but over periods of less than a year, there is literally no rhyme or reason for what has happened. All explanations are simply ex post facto; an expert grasping at straws to assemble a reasonable take on what has occurred, and why it ought to have been obvious to everyone.

Understanding the economy is a helpful exercise. Placing market bets as a result of this understanding is a carnival game on the midway.

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The Difference Between The Stock Market And The Economy