The Market vs. The Economy

People seem to be confused of late. I have heard from radio listeners and clients alike: if the economy is so weak, why is the stock market rising? After all, it is truly perplexing that as more evidence emerges of a weak job market and housing remaining in a slump, stocks have actually gone up—and not by a small amount. What gives?

It stands to reason that what occurs in the economy should certainly impact stock prices. But there is a missing piece in this conclusion: the stock market takes into account what is happening and what will happen, or at least what investors believe could occur in the future. So the economic numbers that you see as headlines today have likely already been factored into the price of stocks. That’s why when the Federal Reserve announces interest rate decisions every six weeks or so, many are focusing on the accompanying statement for clues as to how the central bank will act going forward.

The trend works both ways. On March 17th, US stocks fell to the lows on the year because investors were concerned about the future---what if Bear Stearns was just the first of a handful of investment banks to be in trouble? How would the financial system function under the strain of additional failures? With all of the unknowns, investors sold stocks, until information became clearer. In the weeks since that scary time, we have learned that the Federal Reserve would continue to act aggressively and that there were no other institutions at the Bear Stearns level of problems. As a result, through last Friday’s close, the Dow rallied 9.1% from the March lows and the S&P 500 nearly 11%, at the same time that the US economy has continued to lose jobs and consumer confidence is in the tank.

The theory here is that investors believe that they know all of the bad news that’s out there and every day that something worse does not occur, could mean brighter days ahead. Perhaps that’s why Warren Buffett told Berkshire-Hathaway investors at the annual stockholder meeting last weekend that while bank losses “aren’t over by a long shot,” much of the damage “has already been recognized.” He also noted that a root cause of unrest in March has passed: “The idea of financial panic -- that has been pretty much taken care of.”

With all of this said, expect more negative news about the economy to dribble out, as investors look ahead in their crystal balls to divine whether or not the worst is truly behind us. In other words, don’t expect the market and the economy to move in lock-step.