If the economy is so good, why are stock prices so volatile?
US stock prices peaked in late January 2018 after a steady 15-month advance. Since then, economic news has been very positive-growth is solid, unemployment is low and inflation is tame. Why have stock prices not reflected these good times for the last nine months?
Economists count the stock market as one of a group of “leading indicators”-a discounting mechanism that anticipates the future. That makes sense when you consider current stock prices are the sum of the best estimate of the future earning potential of companies by investors around the world who are buying and selling every day.
So, does the current state of the markets tell us something we can lean on to predict the near future? Often bear markets (defined as a 20% reduction from prior highs) begin before a downturn in the economy. But according to Ned Davis Research, since 1900 there have been 36 bear markets but only 22 recessions. There have been countless more corrections of 10% in the stock market that did not end up turning into a bear market. History will show we had at least two corrections in 2018; some asset classes such as emerging markets fell into a bear market this year.
We experienced two “almost” bear markets in 2011 and 2015-16. In both of those cases, there was no recession or even one quarter of economic contraction. A recession is defined as two consecutive quarters of economic contraction.
Six months ago, Mark Hulbert wrote in the Wall Street Journal, “None of this…should be taken to mean that the stock market doesn’t care about the economy, or that the economy is immune from the wealth effects of a bear market in stocks. But it is surprisingly difficult to translate these undeniable truths into actionable investment advice”.
Reacting emotionally and changing investment strategies in response to short-term declines could prove more harmful than helpful. Diversification and patience are the best weapons against the irreducible uncertainty of investing in equity markets.