From March 24th, 2020 through May 26th, 2020, the stock market, as measured by the S&P 500, returned 36%. That is not typo. Over the same period of time, we have seen a torrent of terrible economic news. For example, on April 24th, the Congressional Budget Office (CBO) released updated economic forecasts that included the following:
- 2Q20 real GDP to decline 12% (40% on an annualized basis)
- Full year estimated 2020 GDP down 5.6%
- Unemployment rate to average 15% in 2Q and 3Q based on expected job losses of 27 million and another 8 million leaving the work force
The central question asked by investors is, how is it possible for the economic news to be this bad with a stock market this good.
In a previous post, I discussed how a simple valuation model showed why it was at least plausible to have extremely poor economic conditions while also seeing strong stock market returns.
A recent article from Dimensional Fund Advisors looks at this conundrum from a different perspective. In their article, they evaluate the basic assumption made by many investors that there is a direct link between current economic and stock market performance.
Specifically, they looked at the historical relationship between contemporaneous GDP and stock market performance and found no clear relationship between the two. They then compared GDP performance to one-year earlier stock market performance and find that market prices do, in fact, react to economic performance, but they do so prior to changes in economic activity.
This analysis supports the concept that the stock market is a massive information discounting machine. Stock and overall market prices are determined by the weighted average expectations of discounted future cash flows. As investors, this is a crucial concept to keep in mind as we navigate through this difficult period. It can help us manage our investment behaviors and, in particular, to not overreact to bad economic news.