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The economy is not the stock market

A few days ago, the Commerce Department reported that May’s factory orders increased by 2.9%. This was well covered by the “press”, because it was going to be a positive influence on the “market” (yes, the quotes are intentional ….. you will see why). Enthusiasm was understandable – $ 394 billion in orders for manufactured goods is the highest level observed since the adoption of the current calculation method. Although being skeptical may be wise, the figure was (and is) an indication that the economy is on a solid footing. However, too often there is a disconnect between what “should” be the result of an economic data and what is actually happening. The economy is not the market. Investors cannot buy shares on factory orders …… they can only buy (or sell) shares. No matter how strong or weak the economy is, you only make money by buying low and selling high. So, together with this, we conducted a study of some of the economic indicators that are treated as if they affect the actions, but not really.

The gross domestic product

The chart below shows a monthly S&P 500 compared to the quarterly increase in gross domestic product. Keep in mind that we compare apples to oranges, at least to a small extent. The S&P index is generally expected to rise, while the percentage growth rate of GDP should remain somewhere between 0 and 5%. In other words, the two will not move in tandem. What we are trying to illustrate is the link between good and bad economic data and the stock market.

Take a look at the chart first, then read our thoughts just below it. By the way, the gross GDP figures are represented by the thin blue line. It is a bit irregular, so to smooth it out, we applied a moving average of 4 periods (one year) of the quarterly GDP figure – this is the red line.

S&P 500 (monthly) versus change in gross domestic product (quarterly) [http://www.bluegrassportfolio.com/images/070705spvsgdp.gif]

In general, the GDP figure was a pretty bad tool if you used it to forecast the growth of the stock market. In zone 1, we notice a major economic contraction in the early 1990s. We saw the S&P 500 retreat by about 50 points in that period, although the decline actually occurred before GDP news was released. Interestingly, this “horrible” GDP figure led to a complete market recovery and then another 50-point rally before the upward trend was tested. In zone 2, a GDP that exceeded 6% at the end of 1999 / beginning of 2000 was going to usher in the new era of share earnings, right? Wrong! The stocks were crushed a few days later … and continued to be crushed for more than a year. In zone 3, the decline in the bear market meant a negative growth rate until the end of 2001. That could persist for years, right? Wrong again. The market hit rock bottom right after that and we are far from the lows that took place in the shadow of the economic contraction.

The idea is, just because the media says something doesn’t make it real. It could take a few minutes, which is great for short-term transactions. But it would be inaccurate to say that it matters even in terms of days, and it certainly cannot count for long-term charts. If anything, the GDP figure could be used as the opposite indicator ….. at least when it reaches extremes. This is why more and more people are abandoning traditional logic when it comes to their portfolios. Paying attention only to charts is not without its flaws, but the technical analysis would have taken you off the market in early 2000 and back on the market in 2003. The final economic indicator (GDP) would have been far behind the market trend in several cases.

Unemployment

Let’s look at another well-covered economic indicator …… unemployment. These data are published monthly, not quarterly. But, like GDP data, it is a percentage that will fluctuate (between 3 and 8). Again, we will not look for a market that reflects 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 the 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? Occupancy was strongest in Area 2, just before stocks sank. Employment was bad at the last minute in zone 3, even when the market ended the bear market. We highlighted a high and low level of unemployment in area 1, just because none of them seemed to affect the market at that time. Like the GDP figure, unemployment data are almost better suited to be the opposite indicator. There is, however, one thing worth mentioning, which is obvious with this diagram. While unemployment rates at the “extreme” ends of the spectrum were often a sign of a reversal, there is a pleasant correlation between the direction of the unemployment line and the direction of the market. The two usually move in opposite directions, regardless of the current level of unemployment. In this sense, logic has at least a small role.

Bottom line

You may be wondering why all the discussions about economic data in the first place. The answer is simply to highlight the reality that the economy is not a market. Too many investors assume that there is a certain cause-and-effect relationship between them. There is a relationship, but it is usually not the one that seems most reasonable. We hope that the graphs above have contributed to this point. That is why we focus so much on graphs and we are increasingly reluctant to incorporate economic data in the traditional way. Just something to think about the next time you are tempted to respond to economic news.

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