Are you puzzled by the divergence between buoyant stocks and the current sinking economy?
Don’t you find it puzzling when one bleak economic report after the other emerges in the press on a nearly constant basis, only to be accompanied by a positive surge in world stock markets on the day when such depressing economic news hit the airwaves? The last few weeks have generated plenty of examples of a stark contrast between daily positive stock market performance and diametrically opposed tanking economic indicators, with depression-level unemployment and the transport and hospitality industry at a complete global stand-still with zero activity during the current global pandemic.
So why the apparent disconnect?
The short answer to this apparent conundrum: Markets are forward-looking. This means that current asset prices reflect the combined aggregate market expectations of all market participants. These expectations encompass all possible future economic developments and their respective impact on future cash flows which ultimately drive today’s stock prices. For example, if the aggregate market expects the economic environment to weaken company cash flows, stock markets typically react well in advance of when the actual observation of such adverse cash flow impacts actually materializes. As renowned economist John Maynard Keynes aptly described in his 1936 book “The General Theory of Employment, Interest and Money”, expectations about the future are already baked into today’s prices and markets are actually designed to be such an expectation processing machine. And the conundrum described in the opening paragraph above gets resolved if it turns out that previous market expectations had been even more pessimistic compared to the elevated depression-level unemployment being reported in today’s news. As such, if things turn out not to be as bad as previously expected, poor economic news as we have seen in the past weeks can and will be greeted with positive stock market performance, as perplexing as this might first seem to be.
The informed reader might now ask herself just how accurate the anticipatory nature of markets really is. To test exactly this accuracy, we perform the following exercise:
Panel A: let’s plot US gross domestic product (GDP) growth vs stock market returns in excess of one-month US Treasury bills (the so-called equity premium)
Panel B: let’s perform the exact same plot as in item a) above, with only one minor adjustment. This time around, we plot GDP growth against each previous year’s equity premium, i.e. we would plot the GDP growth rate of the year 2019 against the equity market returns of 2018, as an example.
If our hypothesis of markets being anticipatory in nature holds true, then we would expect the plot from Panel B to deliver a better correlation compared to the plot from generated in Panel A above
Here are the results going back to 1930:
US GDP growth vs stock market return in the same year (Panel A):
US GDP growth vs stock market return in the previous year (Panel B):
From the two Panels above we can clearly see that:
The spreading out of the dotted blue cloud is larger in Panel A compared to Panel B. As expected by our deliberations at the beginning of this blog, the dots in Panel B group closer to an imaginary upward sloping line compared Panel A. This finding does indeed substantiate the claim that equity markets are anticipatory in nature, functioning as a mechanism which values all expectations about the future of all market participants and incorporating these future expectations into today’s equity market prices. Hence the anticipatory nature of the markets is in fact real. For the statisticians amongst you, the regression coefficients in the second plot have higher explanatory power compared to the first plot.
GDP growth rates are not strongly related to simultaneous stock market returns (Panel A) but are stronger related to each previous year’s stock market return. And this relationship holds true for the entire time series going back to 1930, the first year where we have such comparative data.
On the other hand, markets are not 100% accurate in their anticipatory predictive power about next year's health of the economy. You can clearly see that finding in plot 2. Only if the blue dots had aligned in one straight upward sloping line would we be able to concur that markets are anticipatory with 100% accuracy. And even in the unlikely event that all blue dots had been arranged on one straight line, we would not be able to ascertain that markets could predict next year’s economic GDP growth rate, only the direction of GDP growth rate would then be determined by equity market returns of the previous year.
Some readers will probably interject with the following caveats to our findings above:
But Marc, does this imply that financial markets ignore today’s macroeconomic data as they become available in daily press releases? The answer to this interjection is a clear “No”. Markets don’t ignore such press releases of daily macroeconomic data, they merely weigh the daily macroeconomic data against prior expectations of market participants.
Marc, isn’t it imprecise to only take GDP growth into the considerations above? After all, GDP is a much broader measure of economic activity, and listed companies are only one of many contributors to total GDP. Indeed, you are correct, my dear reader, GDP is indeed also driven by economic activity of non-listed companies. Nevertheless, while GDP may be an imprecise representation of economic activity overall, further academic analysis shows that this is not the only reason for the lack of relationship between GDP growth and simultaneous equity premiums. The finding that equity markets are indeed anticipatory in nature still stands, even in light of GDP growth being driven by both stock-listed and non-listed companies.
Marc, you only show us this relationship for US markets in Panel A and Panel B above, how about all the other global markets? Answer: the picture looks the same in all other markets. The reason we highlight US markets is quite simple: here we have an actual data series going back to 1930, whereas in all other global markets our historical data is much shorter.
While equity market returns are not the perfect predictor of future economic GDP health one year down the road, markets do indeed perform the job of digesting all market expectations of all market participants regarding the future and baking these future expectations into today’s equity market price. Markets are an efficient processing machine to reflect the aggregate market expectation in today’s equity prices. And while it could at first seem puzzling that today’s sky-high unemployment rate is accompanied by positive equity market gains over the past couple of weeks in the middle of a global Covid-19 pandemic, our readers should keep in mind that equity markets are baking expectations about the future into today’s prices.
John Maynard Keynes: The General Theory of Employment, Interest and Money (1936)
<a href="https://www.freepik.com/free-photos-vectors/background">Background photo created by freepik - www.freepik.com</a>