The economy is not the stock market

Some days ago, the Commerce Department reported that May's factory orders had increased by a 2.9 per cent. This was well covered by 'print', as it should be a positive influence on the 'market' (yes, the quotes are intentional ..... you'll see why). The enthusiasm was understandable - the $ 394 billion in orders for manufactured goods is the highest level seen over the current method of calculation was adopted. Although being skeptical can be wise, the figure was (and is) an indication that the economy on a sound footing. However, too often there is a discrepancy between what 'should' be the result of a piece of economic data, and what actually occurs. The economy is not the market. Investors can not buy shares in factory orders ...... you can only buy (or sell) stocks. No matter how strong or weak the economy is, you only make money by buying low and selling high. So, with that, we put together a study of some economic indicators that are treated as if they affect stocks, but I really can not.

Gross Domestic Product

The following table gives a monthly SandP 500 compared to a quarterly growth of gross domestic product. Keep in mind that we are comparing apples to oranges, at least to a small degree. The general index SandP should go higher, while the percentage rate of growth of GDP should be halfway between 0 and 5 per cent. In other words, the two do not move in tandem. What we're trying to illustrate is the connection between good and bad economic data, and the stock market.

Take a look at the first chart, then read our thoughts immediately below that. By the way, the first GDP figures are represented by the thin blue line. It 'sa bit uneven, so as to smooth out, we applied a period of 4 (one year) moving average of quarterly GDP data - which is the red line.

SandP 500 (monthly) against the change in gross national product (quarterly) [http://www.bluegrassportfolio.com/images/070705spvsgdp.gif]

In general, the GDP figure was a pretty lousy tool, if you use it to predict the growth of the stock market. In area 1, we see a major economic downturn in the early '90s. We have seen the 500 SandP pull back about 50 points during this period, although the dip actually occurred before the news of the GDP was released. It is interesting to note that the figure of 'horrible' GDP has led to a total recovery of the market, and then another rally of 50 points before the uptrend was even tested. In Zone 2, a GDP that exceeded 6 percent in late 1999 and early 2000 was to inaugurate the new era of stock gains, right? Wrong! Stocks crushed a few days later .... and kept being crushed for more than a year. In zone 3, the fallout from the bear market meant a negative growth rate by the end of 2001. This may persist for years, right? Wrong again. The market has hit bottom soon after that, and we are well off the minimum that occurred in the shadow of the economic downturn.

The point is, just because the media says something does not make it true. It might matter for some minutes, which is great for short term transactions. But it would be inaccurate to say that it is also important in terms of days, and certainly not important on a long-term charts. If nothing else, the figure of GDP could be used as a contrarian indicator ..... at least when it hits its extremes. For this reason more and more people are abandoning the traditional logic when it comes to their portfolios. Pay attention only to the graphics is not without flaws, but the technical analysis you would get from the market in early 2000, and again in the market in 2003. The final economic indicator (GDP) would be well below the market trend in most cases.

Unemployment

Let's look at another well covered economic indicator ...... unemployment. These data are published monthly rather than quarterly. But, as the GDP data, which is a percentage range (between 3 and 8). Once again, we're not going to look at the market to reflect the rate of unemployment. We just want to see if there is a correlation between employment and the stock market. As above, the SandP 500 appears above, while the unemployment rate is in blue. Take a look, then read below for our thoughts here.

SandP 500 (monthly) than Unemployment (monthly) [http://www.bluegrassportfolio.com/images/070705spvsunemp.gif]

See something familiar? Employment was the strongest in zone 2, right before stocks plunged nose. Employment was at its worst recent Area 3, just as the market ended the bear market. I have highlighted a range of high unemployment and low in area 1, only because it did not seem to affect the market during this period. As the GDP figure, unemployment data is almost better suited to be a contrarian indicator. One thing worthy of note, though, which is evident in this table. While unemployment rates to the 'extreme' ends of the spectrum was often a sign of a reversal, there is a good correlation between the direction of the unemployment line and the direction of the market. The two usually move in opposite directions, regardless of what the level of current unemployment. In this sense, the logic has at least a small role.

Bottom Line

Perhaps you are wondering why all the talk about economic data in the first place. The answer is simply to highlight the reality that the economy is not the market. Too many investors assume there is some cause-effect relationship between one or the other. There is a relationship, but it is usually the one that seems most reasonable. We hope that the graphs above have helped to make this point. That's why we focus so much on the charts, and are increasingly reluctant to incorporate economic data in the traditional way. Just something to think about next time you are tempted to respond to economic news ....