Analysis Economics Market Overview Trading Tips

The Correlation Between The Markets And The Economy

Presently, the markets and real economies entirely seem to lack correlation. Even within the financial markets, equities or bonds/gold appears to be telling a different story. 

Financial markets Vs the economy relationship

The real economy conveys the present situation (essentially, the macro statistics speaks about past event). The financial markets mark-down the future. What this means is if the market forecast is correct, the real economy will reflect the future outlook of the market. It is useless to relate the present macro statistics with the financial markets. Such a relationship can result in wrong conclusions.

The financial markets are not a good representation of the actual economy. For instance, 99% of a country’s economy is commonly made up of small businesses with less than 10 employees. These firms are the most hit by the Covid-19 crisis, while none of these companies are commonly listed on the stock market. The S&P500 commonly include large companies that can easily access capital and regularly gain from healthy balance sheets. It lists global companies and is independent of only one economy.

Besides, the majority of the indices in the stock market are “market-cap-weighted”. What this means is that winners are highly regarded while losers are considered insignificant. There is, thus, a structural survivorship preference in a stock market index with the tendency to steadily overweight the winners among the leaders. Also, this doesn’t show any correlation with the real economy.

Anticipating that S&P500 reflects the US economy by structural construction of the stock indices is a misconception. 

How the markets are related to the true economy

The point in this argument is not to say that the markets and the real economy have no correlation at all. No, there are a couple of facts to bear in mind and these include:

  • The Markets and the economy centers on a different point in time, which can be in the present time or past time or future time.
  • They also reflect different things structurally and can be small businesses against companies with large caps. 

The above two points clearly show that the market and the economy can in the short term show divergent movements. 

Comparing the various segments of the financial market

The equity market, presently, appears to be performing well. The Bonds market as revealed by the revenue is gloomy. Also, the outlook for gold which is the financial safe haven is less than appealing. 

The truth is that the Central Banks’ short-term price interventions and total yield curve have made prices to lose their ability to predict the economy. Put simper, the present level of yield stands for less the market forces and its correlated economic outlook compared to the FED, ECB, and BoJ manipulations. Overall, the present level of the interest rates shows less correlation to the economy compared to the past.

The credit spreads of bonds partly experience similar issues given the Central Banks’ implicit demand that compresses them. Perhaps HY bonds’ credit spreads are better determined by markets’ forces as their low level correlates more with Equities.

The market for Gold is comparatively small. So, large volumes can easily influence the market. Besides being a safe haven asset, it rises with increasing risk aversion. The prices of gold are equally correlated with the price actions of the US dollar, the projections as regards the rate of inflation, and the eagerness of the Central Banks to buy gold to serve as monetary reserves. The factors that affect the short-term rise in the prices of gold are: 

  • The falling USD
  • Projections for higher inflation

The prices of gold are not determined by its ability to serve as the safe-haven asset. 

On the face level, it appears that we get diverging information from different. However, these differing economic messages are much less… different.

The real situation of the economy 

The Stock market doesn’t collapse because of a bad economy because the real economic situation is a reflection of big-cap companies. And it forecasts the future.

A lot of economic analysts think the markets are historically costly. Although this is true, the tendency for them to remain in this state going forward is high because of the low level of interest rates.

The Corona Virus pandemic has triggered large cost cuttings while searching for efficiency profits. Companies are adopting lean management to help them better recover from the recession much leaner so that they will benefit even more from any economic recovery.

Whether the outcomes are good or bad for the financial market doesn’t matter much as whether the outcome is better or worse than projected. The present earning season, particularly in the US and also in Europe is remarkably better than projected!

The short-term steep effects look dangerous, but the long-term effect is less steep and less worrisome.

If you are an investor…

It might be a good time to continue accumulating and not sell as we are near a technical resistance for the S&P500.

Avoid going for bottom fishing. It’ll take a little more time for Airlines and Cruise Operators to fully recover. The reputation of Energy companies has fallen with regard to dividend payers. The banks, particularly European Banks will face issues of rock-bottom rates for a long time.

The best thing to do is to follow the market momentum! And this makes sense because it is the best investment strategy for the past 10 years. While the US does better than Europe, China performs better than Latam. The finance of solid sectors like IT & Communications and Healthcare equally gain from secular trends. Industrials will additionally gain from additional automation and robotization.

The Central Bank policies will continue to make bonds outlook good. Gold is a great option to go for in so far as the uptrend is maintained. Why the rates of USD have fallen more that of the EUR, it’s amazing that the GBP continues to maintain its strength. The Covid-19 pandemic has overpowered the fact that that the BREXIT occurred only 4 months ago.