Financial Health with Raj Shah: Beat the optimism drum (and beat the gloom)

This month I am still banging my ‘optimism is the only realism’ drum – despite the gloomy headlines that screamed out at me from the weekend papers:

‘Economy’s 10% fall was worst for three centuries.’
The ‘Great Lockdown’ slump earns its place in the history books.’ ‘Deepest recession for 300 years.’

And yet, often in the same paper, one can read what seems to be the opposite, such as:

‘Optimistic investors pile into equities.’ ‘House prices surge.’ ‘Markets reach record highs.’

Unless you know the difference between the economy and the stock market, you’d be forgiven for feeling rather confused.

What to believe?

When we think of financial health, a few things might come to mind. We may think of our own financial status, our investments, the ‘market’, the economy, the country’s employment status and so on. While some aspects may be interrelated on some level, they are not all one and the same, nor do they all indicate the status of one another.

The various ways in which we characterise financial wellbeing might explain why so many people think of the stock market and the health of the economy as a gauge for each other. However, the stock market does not define economic health as a whole. As we’ve seen during the recent pandemic, equities are back on the rise, but many individuals – and the country as a whole – are still facing the effects of business closures, record-breaking unemployment rates and more. So why is this? Below, I outline the major differences between the stock market and the economy and why one can progress while the other tells a different story.

What is the ‘economy’?

The economy can be defined as “the wealth and resources of a country or region, especially in terms of the production and consumption of goods and services.”1 As a result, understanding the health of the economy can be thought of in terms of the growth rate of real GDP, meaning whether or not the production of goods and services is increasing or decreasing.2

What is the ‘stock market’?

The stock market can be defined simply as “a stock exchange.”3 It is the buying and selling of ownership shares in a corporation.4 The stock market is comprised, therefore, of the buyers and sellers (with some buyers and sellers holding more ‘stock’ or ‘equities’ than others) and is not necessarily indicative of every business, worker, and family.

The stock market versus the economy

The stock market and the economy can display very different pictures of what we might call ‘progress’. With regards to the stock market, a collection of 500 of the world’s biggest and best financed companies (the S&P 500) surged since the market downturn in March.5 On the other hand, GDP in that market decreased by five percent in 2020’s first quarter, and as of June 2020, the number of unemployed individuals rose to 12 million since February. 6,7

There are many reasons for this apparent disconnect between the markets and the economy and yet this does not stop the financial media constantly agonising over every slight movement up or down in dozens of economic indicators from new home sales to the balance of payments, and from manufacturing capacity utilisation to the producer price index. We are drawn to negative headlines and – as some would say – the role of the media is to keep us in a sustained level of anxiety.

As anyone who has been around economics for any length of time will agree, the waxing and waning of the economy defy consistent anticipation. This is equally true whether the drama is for good or ill: economists missed the productivity gains from the rise of the Internet as completely as they did the looming sub-prime mortgage crisis.

But I think the bigger truth is that some wealth managers/economists labour under the delusion that if they can somehow predict what the economy is going to do next, they can then proceed to anticipate how the markets will respond. They study the economy, in other words, not as a matter of interest for its own sake but as a predictor of markets. This is one of those rare ideas in finance where both the premise and the conclusion are wrong for reasons entirely independent of one another.

The premise is “If we can figure out what the economy is going to do next, we can predict what the market will do.” We can’t—no one consistently can. We don’t have a crystal ball!

If you (or worse still your advisor/wealth manager) do not understand the disconnect, the response to any forecast of an agonisingly slow economic recovery is likely to be “I’m not going to invest until the economy gives me much more positive signals.” And if those signals are not forthcoming, in all likelihood, uninvested is where you will stay. The truth is, if you are waiting for the government to confirm to you that a recession is over, you’ve probably already missed the market.

After the sudden downturn in March last year, equity prices went up in response to the same forces which have always driven them: optimism. Looking back on this historic (and record-breaking) upsurge, we see above all that equities rose not in response to the economy but in spite of it.

Thankfully, our clients are long-term, goal-focused, patient, and disciplined investors who we have coached over time to tune out the meanderings of the economy. In fact, with our help and advanced skills in behavioural coaching, they have learned to tune all current events out.

If you would like to learn more about our approach, please contact us for a no obligation chat.