Why the Stock Market Isn’t the Economy

Sometimes it’s impossible to imagine how different things were a year ago especially if
they’re better manifold now. Stock market participants can agree with me on this- last year at
around this time stock markets were down close to 30% in history’s fastest bear market, travel &
tourism were completely shut down and our modern way of life as we knew it seemed over. In the
midst of all this chaos, a small detail was overlooked- something that was insignificant in face of the
global turmoil but extremely significant for market participants. Stock markets globally bottomed out
on 23rd March 2020, almost a month after they hit all-time highs in mid-February. Back home in
India, the Sensex hit rock bottom on 24 th March 2020 which coincided with the day the Indian
government announced a 21-day (lol) lockdown and a complete shutdown of non-essential business.
From there the Sensex rallied >80% in spite of a deteriorating economy, leading countless investors
to shun the rally (Nifty 5000!!) and miss out on one of the greatest generational buying opportunities
in history.

Conventional knowledge says that the market should’ve started falling AFTER the lockdown
because businesses closed, losses mounted etc. Basically, the conventional thought is that the stock
market should follow the economy because stock markets are a collection of businesses which are
dependent on the economy for functioning. Unfortunately, it is the job of stock markets to spit in
the face of conventional wisdom, to defy commonly perceived logic and fool as many people for the
longest amount of time possible. In this piece I plan to break one of the most common investing
myths- that the stock market follows the economy.

Many of us have heard the phrase ‘The stock market is a discounting mechanism’ but few of
us have been able to apply the principle. What this essentially means is that the stock market is not
concerned with the past or even the present because they are already factored into prices. Stock
markets are forward looking, they represent the future expectations of millions of market
participants. Due to this, stock markets are a leading indicator which predict economic growth which
is a lagging indicator. The economy doesn’t predict the stock market because all available economic
data is of the past and comes with a lag which stock markets reflect investor’ future expectations
instantaneously. The Sensex crashed 30% in March but GDP contracted 24% in June and even after
that. The stock market predicted the economic devastation that the coronavirus pandemic would
cause in the world and that is why global markets went from all time highs to multi-year lows in a
matter of just a month. What most economists failed to understand is that from the moment central
banks and governments announced unlimited liquidity and stimulus checks, the stock markets
started to factor in the greatest economic recovery since the Global Financial Crisis of 2008 which is
what led to one of the most hated rallies in history. It could be a mere coincidence that the stock
markets across the world bottomed out when the Fed (arguably the world’s central bank)
announced its liquidity measures but I personally don’t believe that.

Throughout history stock market declines have preceded periods of economic contractions
and stock market rallies have preceded periods of economic recovery. I believe that when it comes
to financial history, periods of the recent past serve one better than periods of the past, for the
simple reason that the main drivers of markets (central banks and governments) are much different
today than they were decades ago. Here’s what happened to the Dow Jones through the turbulent
times of 2008-9.
We notice that the 2009 playbook of buying the liquidity driven rally after a big crash without caring
about economic fundamentals would’ve produced phenomenal gains in 2020. This is easily said with
the benefit of hindsight but only one investor I know of publicly called March 2020 a 2009 like
buying opportunity – Bill Miller of Miller Value Trust. 1

Many economists look at the stock market in disdain (the same way stock speculators look at
economists) and say ‘The stock market has predicted the last 5 out of 2 recessions’, which though
not impeccable, is a record far better than theirs. I operate with the belief that the only certainty in
this business is uncertainty so I do agree that every fall in the stock market doesn’t herald a coming
recession. The prime example is Black Monday 1987 when the Dow lost 22% of its value in a single
day but no major collapse followed. I do believe however that a swift decline followed by lower lows
should merit some caution and alert investors not to take things at face value. I believe that the
stock market is a leading economic indicator that should be closely observed in periods of
exuberance or depression.
1
Bill Miller March 2020 interview link :