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The Economy Is Not the Stock Market

Several days ago, the Commerce Department reported that May’s factory
orders had increased by a 2.9 percent. This was well covered by ‘the
press’, as it was to be a positive influence on ‘the market’ (yes, the quotes
are intentional…you’ll see why). The enthusiasm was understandable – the
$394 billion in orders of manufactured goods is the highest level seen
since the current calculation method was adopted. Although being
skeptical can be wise, the figure was (and is) a clue that the economy is on
a solid footing. However, too many times there’s a disconnect between
what ‘should’ be the result of a piece of economic data, and what actually
occurs. The economy isn’t the market. Investors can’t buy shares in factory
orders…they can only buy (or sell) stocks. Regardless of how strong or
weak the economy is, one only makes money by buying low and selling
high. So with that, we put together a study of some of the economic
indicators that are treated as if they affect stocks, but really may not.

Gross Domestic Product
The chart below plots a monthly S&P 500 against a quarterly Gross
Domestic Product growth figure. Keep in mind that we’re comparing apples
to oranges, at least to a small degree. The S&P index should generally go
higher, while the GDP percentage growth rate should stay somewhere in
between 0 and 5 percent. In other words, the two won’t move in tandem.
What we’re trying to illustrate is the connection between good and bad
economic data, and the stock market.

Take a look at the chart first, then read our thoughts immediately below
that. By the way, the raw GDP figures are represented by the thin blue line.
It’s a little erratic, so to smooth it out, we’ve applied a 4 period (one year)
moving average of the quarterly GDP figure – that’s the red line.

S&P 500 (monthly) versus Gross Domestic Product change (quarterly)
http://www.bluegrassportfolio.com/images/070705spvsgdp.gif

Generally speaking, the GDP figure was a pretty lousy tool, if you were
using it to forecast stock market growth. In area 1, we see a major
economic contraction in the early 90’s. We saw the S&P 500 pull back by
about 50 points during that period, although the dip actually occurred
before the GDP news was released. Interestingly, that ‘horrible’ GDP figure
led to a full market recovery, and then another 50 point rally before the
uptrend was even tested. In area 2, a GDP that topped 6 percent in late
1999/early 2000 was going to usher in the new era of stock gains, right?
Wrong! Stocks got crushed a few days later….and kept getting crushed for
more than a year. In area 3, the fallout from the bear market meant a
negative growth rate by the end of 2001. That could persist for years, right?
Wrong again. The market hit a bottom just after that, and we’re well off the
lows that occurred in the shadow of that economic contraction.

The point is, just because the media says something doesn’t make it true.
It might matter for a few minutes, which is great for short-term trades. But it
would be inaccurate to say that it even matters in terms of days, and it
certainly can’t matter for long-term charts. If anything, the GDP figure could
be used as a contrarian indicator…at least when it hits its extremes. This is
why more and more folks are abandoning traditional logic when it comes to
their portfolios. Paying attention solely to charts is not without its flaws, but
technical analysis would have gotten you out of the market in early 2000,
and back into the market in 2003. The ultimate economic indicator (GDP)
would have been well behind the market trend in most cases.

Unemployment
Let’s look at another well-covered economic indicator…unemployment. This
data is released monthly, instead of quarterly. But like the GDP data, it’s a
percentage that will fluctuate (between 3 and 8). Again, we’re not going to
look for the market to mirror the unemployment figure. We just want to see
if there’s a correlation between employment and the stock market. Like
above, the S&P 500 appears above, while the unemployment rate is in
blue. Take a look, then read below for our thoughts here.

S&P 500 (monthly) versus Unemployment rate (monthly)
http://www.bluegrassportfolio.com/images/070705spvsunemp.gif

See anything familiar? Employment was at it strongest in area 2, right
before stocks nose-dived. Employment was at its recent worst in area 3,
right as the market ended the bear market. I highlighted a high and low
unemployment range in area 1, only because neither seemed to affect the
market during that period. Like the GDP figure, unemployment data is
almost better suited to be a contrarian indicator. There is one thing worth
mentioning, though, that is evident with this chart. While the unemployment
rates at the ‘extreme’ ends of spectrum was often a sign of a reversals,
there is a nice correlation between the direction of the unemployment line
and the direction of the market. The two typically move in opposite
directions, regardless of what the current unemployment level is. In that
sense, logic has at least a small role.

Bottom Line
Maybe you’re wondering why all the chatter about economic data in the first
place. The answer is, simply to highlight the reality that the economy isn’t
the market. Too many investors assume there’s a certain cause-and-effect
relationship between one and the other. There’s a relationship, but it’s
usually not the one that seems most reasonable. Hopefully the graphs
above have helped make that point. That’s why we focus so much on
charts, and are increasingly hesitant to incorporate economic data in the
traditional way. Just something to think about the next time you’re tempted
to respond to economic news.

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