The economy is not the stock market

Several days ago, the Commerce Department reported that May factory orders had risen 2.9 percent. This was well covered by ‘the press’ as it was going to be a positive influence on ‘the market’ (yes, the quotes are intentional … you’ll see why). The excitement was understandable: The $ 394 billion in manufactured product orders is the highest level seen since the current calculation method was adopted. While being skeptical may be wise, the figure was (and is) a clue that the economy is on a solid footing. However, there is often a disconnect between what “should” be the result of an economic data and what actually happens. The economy is not the market. Investors cannot buy stocks on factory orders … they can only buy (or sell) stocks. Regardless of how strong or weak the economy is, you only make 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 in reality they may not.

Gross domestic product

The graph below plots a monthly S&P 500 against a quarterly Gross Domestic Product growth figure. Note that we are comparing apples to oranges, at least to a small extent. Generally, the S&P index should rise further, while the percentage growth rate of GDP should remain between 0 and 5 percent. In other words, the two will not move together. What we are trying to illustrate is the connection between good and bad economic data and the stock market.

Take a look at the table first, then read our thoughts immediately below it. By the way, gross GDP figures are represented by the thin blue line. It’s a bit 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 change in Gross Domestic Product (quarterly) [http://www.bluegrassportfolio.com/images/070705spvsgdp.gif]

Generally speaking, the GDP figure was a pretty lousy tool, if you used it to forecast stock market growth. In area 1, we see a major economic contraction in the early 1990s. We saw the S&P 500 retreat around 50 points during that period, although the drop actually happened 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 tested. In area 2, a GDP that exceeded 6 percent in late 1999 / early 2000 was going to usher in the new era of equity gains, right? Wrong! Stocks crushed a few days later … and they continued to crush for over 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? Again wrong. The market bottomed out right after that, and we are well off the lows that occurred in the shadow of that economic contraction.

The point is that the fact that the media says something does not make it true. It can be important for a few minutes, which is great for short-term trading. But it would be inaccurate to say that it even matters in terms of days, and it certainly cannot matter for long-term charts. In any case, the GDP figure could be used as a counter indicator … at least when it reaches its extremes. This is why more and more people are abandoning traditional logic when it comes to their wallets. Paying attention to the charts alone is not without its flaws, but technical analysis would have taken it off the market in early 2000 and back on the market in 2003. The final economic indicator (GDP) would have lagged far behind the trend of the market in most cases.

Unemployment

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

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

Do you see anything familiar? Employment was at its strongest in Area 2, just before stocks plummeted. Employment was at its worst recent moment in area 3, just as the market ended the bear market. I highlighted a range of high and low unemployment in area 1, just because neither seemed to affect the market during that period. Like the GDP figure, the unemployment data is almost better suited to be a counter indicator. However, there is one thing worth mentioning that is evident from this graph. While unemployment rates at the ‘extreme’ ends of the spectrum were often a sign of reversal, there is a good correlation between the direction of the unemployment line and the direction of the market. The two generally move in opposite directions, regardless of the current unemployment level. In that sense, logic plays at least a small role.

Bottom line

You may be wondering why all the economic data chatter in the first place. The answer is simply to highlight the reality that the economy is not the market. Too many investors assume that there is a certain cause and effect relationship between one and the other. There is a relationship, but it is usually not the one that seems most reasonable. Hopefully, the charts above have helped clarify that point. This is 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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