Michael Keaveney, Head of Morningstar Investment Management, Canada, explains why major swings in global equity markets are inevitable.
What accounts for the disconnect between the economy and the stock market?
First of all, we have to acknowledge that they are not the same thing. When it comes to the stock market, we're talking about a narrower focus than the broad economy, it's publicly-traded companies.
The barometer that people focus on there is market price which is very much determined through the buyer and seller interaction. That takes a view on things that will happen in the future, like future company profits.
An economy is a system that encompasses much more than just the stock market. It's the government sector, it's not-for-profits and other for-profits that are not necessarily publicly traded. The barometer that people focus on here are data points like Gross Domestic Product, or GDP, which given the complexity of the system is often posted after the fact.
So the main disconnect is the frame of reference. It's backwards-looking for a lot of economic data and forward-looking for the stock market.
Now, we shouldn't dismiss that there is any connection between the two. In aggregate and over longer periods, the returns of the stock market are supplied by the real economy and corporate fundamentals. There's a colorful metaphor used by an economist Roger Farmer to describe the relationship between the stock market and the economy, and that's of two staggering drunks tethered together by a long rope. They can go often their own directions independently, but because they are tied together they can never get too far apart.
Is it inevitable that global markets will experience major swings every so often?
I think so, and it's important to keep reminding ourselves of that because our investment memory sometimes fails us. There is no shortage of very accessible reading on the history and, by inference, the inherent inevitability of that sudden swing behavior.
If you look at books like Extraordinary Popular Delusions and the Madness of Crowds that was written by Charles Mackay in the 1840s, it talks about themes that are still relevant today. Manias, Panics and Crashes, that's more recent. That was written in 1978 by Charles Kindleberger, but it goes back to stuff that happened from the 1600s onwards. It's now in its sixth edition. So, since he originally wrote it, we've had the 1987 stock market crash, we've had the dot-com bubble, we've had the financial crisis of 2008 and 2009. So there is no shortage of reference points to say that it has always happened.
In fact, there is a quote that I like to use that sums it up: "We seem to have a once-in-a-lifetime crisis every four or five years."
How should investors factor in the economy when making investing decisions?
Well, they have to recognize that economic data is backward-looking and that's the type that's most readily available to us from official and public sources. That's of very, very little value to investors.
Forecasting economics or forward-looking economic forecasts can be useful; however, there are lots of different forecasts out there. They are not always going to be correct. So you have to choose wisely.
I would also say that you should avoid relying on a single economic indicator or, for that matter, the analysis of anybody who relies on the same type of analysis. A recently published book by Philip Tetlock called Superforecasting: The Art and Science of Predicting identifies a number of qualities useful for making good forecasts that are relevant in this particular issue, and that includes recognizing the complexity of reality, not being wedded to a single idea or agenda and then changing your mind when the facts change.
How should lawmakers factor in the stock market when setting economic policy?
Well, the stock market is a significant source of wealth for most people, whether they realize it or not, whether they are directly investing themselves or the investments are being done on their behalf through a public pension plan or indeed a private pension plan. So it is important.
But when it comes to the stock market, I think governments should focus more broadly on policies that promote transparency so that people are in a better position to make informed investment decisions that are in their best interest over the long term. And then governments should also be aware that their economic policies create winners and losers, whether that's by design or inadvertently. So, they need to pay attention on the effects on those who might not come out on top.
This article initially appeared on Morningstar Canada.
