Today’s Headlines: The Stock Market Versus the Economy

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Today’s Headlines:  The Stock Market Versus the Economy
September 1, 2021

Volatility Rules in the Market

Over the last two weeks, the main winners in the gyrations of the stock market may have been antacid companies. When the week opens with an 1,100-point drop in the Dow within five minutes, it's a safe bet the rest of the week will be stomach-churning, regardless of economic fundamentals.

The Dow, NASDAQ, and S&P 500 all joined in, taking investors on a wild ride but rebounding to close slightly up for the week. Following successive daily drops of 587 and 206 points, the Dow rose 619 points and 369 points in the next two days for the largest two-day point gain ever. A slightly down Friday left the Dow up for the week by around 1%. The NASDAQ reversed an almost 9% drop to end up ahead 2.6% for the week, and the S&P 500 recovered from a drop of over 5% to finish the week at just under a 1% gain.

All this turbulence comes at a time when signs point to increasing strength in the US economy. If the US economy really is getting stronger, why are US stock markets so volatile? The broad answer: the economy is much more than the stock market, and vice versa. It's not uncommon for the stock market to lead, lag, or head in the opposite direction from the broader economy.

Connected, Yet Distinct

One thing the stock market and broader economy do have in common is a mixture of economic fundamentals and psychology.

The stock market is a measure of the perceived value of companies, as it reflects what people are willing to pay for their shares at any given point in time. Investors evaluate price using objective criteria, such as revenue/earnings, sales, expense, cash flow, assets, and profit, while other measures are subjective and based in the future. What are growth and earnings predicted to be? Is market share expected to increase or decrease?

Throw in herd mentality and the occasional panic, and the stock market is at least as much about the psychology of the future as it is the economic fundamentals of the present.

Conversely, the economy boils down to basic principles of supply and demand. Is there a sufficient demand for manufactured goods and services to promote growth in manufacturing and service sectors? Do consumers have enough funds available to pay for them? What external factors are acting on these forces (value of the dollar, central bank policies, actions of trading partners, etc.)?

The psychology of the economy comes into play at both the consumer level and financial level. Even if they have the money, do consumers feel confident enough about their job situation, total debt, and current wages to make discretionary purchases? On the central bank and legislative side, do officials feel the need to raise or lower interest rates, print more money, or create spending stimulus to "prime the pump?"

The best way to sum up the connection is that the psychology of the market reacts to the psychology of the economy, with underlying objective facts that either strengthen or weaken the current arguments. The disconnect is that the market is less concerned with fundamental supply and demand, and more so with future expectations.

That concept brings us to the past week, where stocks were falling broadly, as some investors let psychological factors override economic fundamentals and pulled out of all stocks instead of evaluating individual stock performances and the underlying fundamentals. During 2008, there were fundamental issues within the US economy that drove a stock market plunge while suggesting continued trouble in the near-term future. That's not the case in 2015.

US Economy Gains Momentum

Economic news has been relatively bright for the US lately. Second-quarter GDP was adjusted upward from 2.3% to a 3.7% growth, and the first quarter pulled out of the red to show a 0.6% growth. Second quarter growth was broad-based and includes business investments and spending from both consumers and government. Consumer spending was revised up to 3.1% in the second quarter, and the Consumer Confidence Index rebounded sharply to 101.5 in August from a reading of 91 in July.

The stubborn housing market has finally begun to show improvement as well. Both pending and existing home sales rose in July. Spending on home building/improvements in the second quarter improved by 7.8%, on top of a 10.1% first quarter gain.

Second-quarter corporate earnings were mixed, but still above estimates for many large companies. The recent drop brought forward price-to-earnings (P/E) ratios down to a reasonable 16-17 range for the Dow Industrials and the S&P 500. In essence, the US economy is still sound and growing, and should continue to grow — although not as fast as some would like. The strong dollar and reduced worldwide demand should keep growth slow in the short term.

Meanwhile, from the stock market perspective, a few distorting factors remain. By keeping interest rates at historic lows for several years, the Fed has driven money toward stocks, as they are the only refuge for decent returns. Once the Fed actually does raise rates, the stock market should return to an emphasis on fundamentals — i.e., less psychology and more economics.

Concern about China will continue to distort US equity markets as well, although it's less about the state of the Chinese economy than it is uncertainty about how the Chinese government will react, and how their actions might snowball across the global economy. Expect the market to continue to be volatile while the economy chugs along at a slower, steadier growth pace within that volatility.

The Takeaway

You cannot ignore psychological factors when deciding what to do with your portfolio, but don't let them overwhelm the economic fundamentals. Investors who remained calm through the fall and successfully identified buying bargains (and losing stocks) made money. Those who engaged in panic selling across the board without regard for long-term value lost money. That was true for both the long-term investors and speculators attempting to make money on individual stocks.

Your decision to adjust exposure to individual stocks or entire sectors should be based on your age with respect to retirement, your risk tolerance, and your financial needs — not the momentary variations of the market. If you can’t handle market fluctuations like last week's, reduce your exposure to stocks accordingly — but adjust your retirement expectations as well. It's better to be happy with a more frugal lifestyle than to be a nervous wreck trying to maintain a higher one.

Photo © Horrocks

  Conversation   |   26 Comments

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Daniel | 09.01.15 @ 16:08
Seems like tough times. We'll have to hope it levels out and bounces back...but may be a good time to sit with an advisor and weigh out options.
Kamie | 09.01.15 @ 16:08
I have chosen to not look at my stocks for the last month. I have read everywhere that some of the best things are dropping. I do not want see.
Victor | 09.01.15 @ 16:17
It's hard to believe that two things that should have so much in common will take different ways - one going up and the other down. That is why we need a broader understanding.
Andrea | 09.01.15 @ 16:18
I just don't understand the stock market or the DOW stuff. Perhaps I need to start learning catch up.
STOKES | 09.01.15 @ 16:18
I've always diversified my portfolio as much as possible. It's a good time to buy. I have faith that the market will bounce back.
Steffanie | 09.01.15 @ 16:20
Hoping to see things bounce back soon.
Rindy | 09.01.15 @ 16:20
The economy seems better to me so I don't understand this up and down of the stock market.
Jackie | 09.01.15 @ 16:25
Although I'm tempted to sell off my stocks to keep from losing more money, I'm holding off to see if the market will rebound.
Nancy | 09.01.15 @ 16:25
"Herd mentality" is not a comforting aspect in any place in society, but especially in the economy. When you deal with people it's to be expected though.
Crystal | 09.01.15 @ 16:27
It seems like in the long run it levels out and you make money on your investments
Apryl | 09.01.15 @ 16:35
It's a risk no matter what.
Beverly | 09.01.15 @ 16:35
I'm a safe investor and don't like to play the market, especially in this day and age. The market is not acting like it is supposed to because you have people behind the scenes tinkering with things to give everyone a feeling of complacency. I also don't trust any numbers that come from this administration. Jobs may be up, but they are mostly all part-time...People can't live off part-time. Seems like the safest bet is to keep the money under your least you won't lose it that way.
Carla | 09.01.15 @ 16:41
This is when it pays to have a good financial advisor. The risks involved in the stock market really scare me.
Erin | 09.01.15 @ 16:42
I'm so glad that we have a good advisor who helps us through these ups and downs.
gracie | 09.01.15 @ 16:44
So many people took a huge loss on stocks previously that it's understandable for nerves to be rattled when they see the stock market rising and falling so dramatically.
Sarah | 09.01.15 @ 16:46
I have never gotten into stocks, but if I ever were to, I think I'd just leave it to a professional.
trish | 09.01.15 @ 16:56
I am not confident enough to go this road alone. I would need to have a highly knowledgeable and trusted financial adviser to ride this one with me.
Alec | 09.01.15 @ 16:57
The only worry I've had about the stock market, since I don't invest in it, is what effect it would have on the economy. I'm happy to see that gas is down by 20 cents per gallon where I live for the past week, but aside from that I haven't seen any positive or negative effects. I hope the economy keeps growing and that we outside the market don't see anything negative come from the massive fluctuations.
Elaine | 09.01.15 @ 17:13
I'm just trusting things will not get as bad as they are projecting. I don't have any stocks but I would hate to hear of family members having to deal with this.
Chrisitna | 09.01.15 @ 17:17
I wish the stock market made more sense to me...I would like to be more confident choosing stocks to make money!
Heather | 09.01.15 @ 17:30
It's times like this when you just need to weather the storm. Things will bounce back. Just don't make rash decisions right now.
Sara | 09.01.15 @ 17:34
This is one of the reasons I have yet to buy in the stock market. Things are too unpredictable.
Britt | 09.01.15 @ 17:57
It feels like it's been pretty tough times for a lot of us since we went through the horrible '08 recession. Amazing that two things that seem like they go hand-in-hand, actually don't.
Angie | 09.01.15 @ 18:19
Kamie, it's the same for me. We've always been advised to hang in there, but I don't want to see yet just how badly they've been impacted.
Zanna | 09.01.15 @ 19:40
The market is better watched over the long-term, rather than obsessing over the ups and downs. People panic too often over what will turn out to be minor changes, if looked at over time.
irene | 09.01.15 @ 19:41
What money we can afford to put aside is in a low risk annuity and even that has lost a little bit of money
$commenter.renderDisplayableName() | 11.27.20 @ 16:35