“Dear David, Stock markets and economies, correlated or random? On the much discussed/misunderstood correlation between major stock markets and their regional economies. I see often the "financial entertainers" on the main 2 US Financial TV channels the "experts" predicting stock markets on the dubious basis of well or badly performing economies which maybe true on a long term basis but just look at the example of 2009 (and many others) when the US and EU were at the start of major recessions and economic troubles (EU still is Mario) and conversely the major stock markets were supercharged from March onwards resulting in the nearest thing to traders heaven! This looks retrospectively like an almost inverse correlation. Are there any studies quantifying the relationship between these 2 conditions, ie strengthening economies/high performing stock markets? What is your personal view?”

David Fuller's view

Many thanks for your extremely important points and questions on a complex subject, certain to be of interest to most investors.  One could write at length on this subject, although I will resist that temptation.  Instead, I will try to identify some of the relevant elastic strands which loosely connect market realities and investors’ expectations.

Over the very long term, as you indicate, there will be an obvious correlation between the performance of an economy and its underlying stock market.  However, markets are vastly more volatile than changes in GDP performance, not least because of investor’s expectations.  This volatility is even more dramatic in the performance of individual shares, which move in and out of favour over the lengthy medium term, in line with their changing earnings, external influences and investor expectations.  It is for this reason that our research firm pays attention to Behavioural and Factual Technical Analysis, which we have helped to develop over the last forty-five years. 

The email above also points out the apparent inverse correlation between stock markets and economic performance, not least as we have seen since the end of 2008.  That is because a big global bear market will significantly lower stock market valuations and also investors’ expectations.  This will cause central banks to slash interest rates and pump liquidity into the system.  At such times savvy investors will recall the adage: ‘Don’t fight the Fed’, and rightly so. 

Today’s major concern, in my opinion, is when will the Fed and other central banks remove their monetary punch bowls, and raise short-term interest rates to restrain inflationary pressures as global economies strengthen?   My guess is that the Fed will delay this step until sometime next year at the earliest, and proceed cautiously when they do commence raising rates.  There are several reasons for this:

1) It takes years to revive GDP growth after a serious credit crisis recession, as I have often mentioned, because both corporations and consumers enter a lengthy period of deleveraging which reduces tax revenues to their respective governments.  2) Inflationary pressures, at least those reported by most governments, remain subdued.  Additionally, government bond yields are historically low, not least in developed economies, due to slow GDP growth and especially Quantitative Easing (QE).  The Fed will not have a bond market warning until US 10-Yr Treasury yields are on the other side of 3%.  3) The European Union is way behind the USA in terms of economic recovery.  4) Global uncertainty, from the Russia-Ukraine border to unrest in the Middle East, is a headwind for GDP growth.