Should Stock Investors “Fret Over Economy”? No — See Chart to Understand Why

The idea that the economy leads the stock market is false

As the DJIA fell 2% to close below 12,000 on August 2, one theme rang across major financial websites. This CNN headline summarizes it:

Stocks sink as investors fret over the economy (Aug. 2)

The belief that the economy drives the stock market is common knowledge; it’s Investing 101; the idea gets pounded into investors’ heads, over and over again, by various pundits, daily.

But please allow us to suggest this: Belief that the GDP and other economic measures drive stock market trends is completely and utterly false.

The strength or weakness of the economy does not lead the stock market higher or lower. The economy follows the stock market.

Stocks lead the economy, normally by months,” writes EWI president Robert Prechter; he has studied this subject in-depth. Here’s an excerpt from our Club EWI resource, the free 50-page 2011 Independent Investor eBook, which quotes one of Prechter’s research papers.

The Independent Investor eBook, 2011 Edition
(excerpt; get full eBook here, free)

Suppose that you had perfect foreknowledge that over the next 3¾ years GDP would be positive every single quarter and that one of those quarters would surprise economists in being the strongest quarterly rise in a half-century span. Would you buy stocks?

If you had acted on such knowledge in March 1976, you would have owned stocks for four years in which the DJIA fell 22%. If at the end of Q1 1980 you figured out that the quarter would be negative and would be followed by yet another negative quarter, you would have sold out at the bottom.

Suppose you were to possess perfect knowledge that next quarter’s GDP will be the strongest rising quarter for a span of 15 years, guaranteed. Would you buy stocks?

Had you anticipated precisely this event for 4Q 1987, you would have owned stocks for the biggest stock market crash since 1929. GDP was positive every quarter for 20 straight quarters before the crash and for 10 quarters thereafter.

But the market crashed anyway. Three years after the start of 4Q 1987, stock prices were still below their level of that time despite 30 uninterrupted quarters of rising GDP. Figure 10 shows these two events.

It seems that there is something wrong with the idea that investors rationally value stocks according to growth or contraction in GDP. (…continued)

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