Are you puzzled when the media broadcasts bleak economic or health reports from yesterday, only to be accompanied by upwardly surging stock market prices? You’re not alone. The last few months produced many examples of astonishing stock market performance and economic indicators putting the U.S. in recession. So what explains the disconnect?
Markets are forward-looking when pricing stocks or any other security. That means, today’s asset prices are highly efficient in aggregating future expectations of market participants collectively. Today’s news is already old for making investment decisions. Expectations of profit-seeking participants such as hedge fund traders have already anticipated likely future economic developments such as the timeliness of a recovery and how that may impact the future profitability for those companies that survive the crisis.
Profits from anticipated revenues for years in the future are key to estimating a stock’s price today. For example, if the market expects an economic environment to weaken company cash flows to make firms less profitable (say from new government policy due to virus resurgence), markets will react well in advance of a formal news announcement. Expectations from any new information is rapidly embedded in stock prices—often in seconds—as profit-seeking participants “vote” their profit expectations in real time.
Of course, an upward or downward direction of stock market prices depends on how well realized information compares to collective expectations of investors. If news of results are better than expected, even what could appear as “bad” news can be greeted positively by financial markets. For instance, if profitability has improved relative to what markets had priced into their expectations, stock prices may jump when what appears as “bad” news (such as a dividend reduction) is released if that reduction is not as much as expected.
LOOKING OUT FAR AHEAD
The anticipatory behavior of markets can be illustrated using U.S. gross domestic product (GDP) growth as a proxy for current profitability and its relationship to equity premiums (stock market returns in excess of risk-free U.S. Treasury bills). Plots in Exhibit 1 show no discernable relation between U.S. equity premiums and GDP growth for the same year. Changes in GDP are obviously not strongly related to stock market returns in the same year.
This result does not imply financial markets are ignoring macroeconomic data. After all, GDP encompasses multiple economic measures that seriously impact corporate profits. However, while growing GDP imprecisely represents activities driving stock prices upward, more analysis shows how the popular media narrative of a direct relationship is incorrect.
When we plot GDP growth against the previous year’s equity premium (shown in the bottom panel of Exhibit 1) a noticeable relationship suddenly appears. The positive trend in the data upward to the right suggests market prices are responding to GDP changes. However, prices did so in advance of realized economic developments. This result — at odds with popular belief — is consistent with the best financial theory and research. Markets prices in publicly traded markets “efficiently” incorporate economic growth expectations long before those outcomes are realized and reported by the media.
Exhibit 1: Plot Development
US equity premium vs. GDP growth, 1930-2019
Annual GDP growth rates obtained from the US Bureau of Economic Analysis. GDP growth numbers are adjusted to 2012 USD terms to remove the effects of inflation. Annual US equity premium is return difference between the Fama/French Total US Market Research Index and One-Month US Treasury Bill. Equity premium data provided by Ken French, available at mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html. “One-Month Treasury Bills” is the IA SBBI US 30 Day T-Bill Total Return, provided by Ibbotson Associates via Morningstar Direct.
This brings us to new headlines that affect your planning: the financial fallout from multi-trillion-dollar government expenditures intended to ease the burden of government mandated shutdowns. Will those trillions being spent create a financial burden for the U.S. government and for its citizens as higher taxes in ways that adversely affect stock returns?
The results in Exhibit 2 may allay concerns regarding how those huge expenditures may impact equity market performance. When we sort countries each year on their debt-to-GDP for the prior year (top panel), average annual equity premiums have been slightly higher for high-debt countries than low-debt countries in markets globally. However, the return differences’ small t-statistics — a measure of the precision of a value’s estimate and thus its validity — suggest these averages may not be reliably different.1
But it could be that markets more focused on where professional investors expect the amount of that debt to end up, rather than on where it’s been. The top panel uses prior year debt-to-GDP data to sort countries into the high/low groups. In the bottom panel of Exhibit 2, we rank countries on debt-to-GDP at current year-end, assuming perfect foresight of end-of-year debt levels. Again, we see average equity premiums similar for high- and low-debt countries. Like the results for GDP growth, these results imply that markets have already priced in expectations for future government debt and business profitability risk.
Exhibit 2: Debt Defying
Average equity premiums for countries sorted on debt
All returns in USD. Countries are sorted at the beginning of each year. High-Debt and Low-Debt refer to countries above and below the median debt, respectively. Debt is general government debt and central government debt. Source: The International Monetary Fund. Equity market returns represented by MSCI country indices. Dimensional Fund Advisor LP calculations from Bloomberg and MSCI data. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.
CONCLUSION: MARKETS AND PLANNING
Macroeconomic variables and investment decisions are like frozen turkeys and deep fryers — extreme caution should be exercised when used in combination. These studies are consistent with the notion of markets as information processing machines. Vast sets of macroeconomic indicators and their expectations are processed into what we see as market prices. The ironic result is that stock markets in the form of indexes like the S&P 500 are themselves perhaps among the best leading macroeconomic indicators we have.
Since markets are such good predictors of economic conditions, their short-term movements are fiendishly unpredictable. For planning, we assume their movements are essentially random. It should not surprise us that survivorship of mutual funds and hedge funds focused solely on what is called “market timing” has been abysmally low. Fortunately, with modern financial science at the core of a wealth management strategy, you don’t need to out-guess the markets or economy for reliable life goal outcomes.
Over time, capital markets have consistently rewarded those with a long-term perspective who remained disciplined in the face of market surprises. No matter what you may read in the media, there are no miracle products to save you if you saved too little or spent too much. In my years as a CFP® professional, I’ve never seen one that paid off both very well and for very long. The new “structured products,” like so many varieties of hedge fund schemes that came before them, were devised to be sold, not owned.
But through an informed wealth management process that collaborates with a knowledgeable firm of CFP® professionals and other specialists, you can position yourself to make the most of what markets and integrated planning have to offer. And through the right strategy for achieving your life goals, you can have peace of mind even during a crisis.
1Researchers often cite a t-statistic value of 2.0 as the threshold for statistical reliability.
- Macroeconomic data: Data used to measure the output of an economy, such as employment or production.
- Gross domestic product: The total value of goods and services produced by, for example, a country over a set period of time.
- Debt-to-GDP: The ratio of a country’s debt to its gross domestic product.
- Fama/French Total US Market Research Index: The value-weighed US market index is constructed every month, using all issues listed on the NYSE, AMEX, or Nasdaq with available outstanding shares and valid prices for that month and the month before. Exclusions: American depositary receipts. Sources: CRSP for value-weighted US market return. Rebalancing: Monthly. Dividends: Reinvested in the paying company until the portfolio is rebalanced.