Does The Economy Drive The Stock Market?

What drives the capital markets? Is it the economy or something else? The short answer of course is the economy, but only over the long term. There is much more to it than a simple, if A then B.

I recently read an excellent article by Kel Kelly (writer and former trader)who ties the business cycle into the relationship between the economy and the markets. I thought I would share my interpretation of some of his thoughts with you. This will take several articles but I think you will get a better understanding of the relationship between the market and the economy.

If you listen to the pundits and the media, you get the impression that capital markets are driven by things like:

1. Psychology or crowd behavior or “animal spirits”,consumer sentiment or
2. Technological analysis or patterns of behavior (charts), instant correlations or
3. Data points like corporate earnings or expected earnings, revenues or
4. Marginal economic data points like consumer spending, interest rates, GDP growth, increasing or decreasing labor costs, etc.

In the real world, the most common view is that the economy drives the markets. As the economy (GDP) grows, corporate revenues and profits grow. This growth increases profits and the value of the company, which is then reflected in the stock price. The reverse is also true; if the growth rate of the economy declines, profits are reduced and stock prices fall.

While this view is basically correct, over the long term; you could have a difficult time predicting where the market is headed in the short-term. I looked at the quarterly, rate of change in the economy and the S&P500 over the past ten years. The correlation for the two is 0.40. Not that strong a relationship.

Yet, most economists and pundits today use at-the-margin data points (for example, a monthly turn in the data, a two or three month trend, etc.) to predict the future direction of the economy. This is a backward looking view of the economy not a forward-looking view. Plus, they are always waiting for the next data point rather than making a definitive decision. By the way, you have to stay tuned for tomorrow’s new, backward-looking data.

Can you remember the last time one of these projections was correct? Just to add a little humor into this, how about the National Bureau of Economic Research’s ruling a few weeks ago, after 18 months of rigorous analysis, that the current recession ended in March of 2009.

Real force driving the stock market

Over the next few articles, I hope to show that the real force driving the market, over the longer term, is changes in the quantity of money and the volume of spending in the economy. This precedes the rise in GDP (economy.) In other words, capital markets rise when the money supply is inflated and stocks fall when the money supply contracts (note: they can fall for other reasons as well.)