Australia is in its deepest recession since the 1930s, yet the stock market is only down modestly this year. In the US, where the virus has claimed 160,000 lives and left unemployment above 10%, the market is near record highs.
Are markets full of ‘blind optimists’ immune to bad news? Or is it just that the economy is not as bad as it sounds?
The answer starts with recognising that markets are forward-looking. Bad news gets priced in quickly, as we saw in downturn in March. Then the market calibrates its view. Its eventual path will depend on how economic outcomes compare to expectations.
Those expectations include whatever future economic developments are anticipated and their potential impact on cash flows, which are key to a stock’s value. For example, if the market expects the economic environment to weaken company cash flows, stock markets may react well in advance of when the actual impact is observed.
The eventual direction of the stock market will depend on how the economic outcome compares to expectations. If things aren’t as bad as expected, poor economic news can be greeted with a positive stock reaction.
The anticipatory nature of markets is observed by looking at the relationship between the official announcement of a recession and stock market returns. The following illustration shows the U.S. market factoring in poor economic conditions months prior to the official announcements.
Markets at Work
Macroeconomic variables and investment decisions are like security guards and quarantine — great caution should be exercised when combining the two.
Markets aggregate and process vast sets of macroeconomic indicators. By incorporating this information into stock prices, public capital markets effectively become the best available leading macroeconomic indicator.
At WARR HUNT, we believe that all successful investing is goal focused and planning driven. And all failed investing is market focused and current outlook driven.
Image Source: Morningstar Direct. Any advice in this publication is of a general nature only and has not been tailored to your personal circumstances. Please seek personal advice from WARR HUNT prior to acting on this information. Before making a decision to acquire a financial product, you should obtain and read the Product Disclosure Statement (PDS) relating to that product. Past performance is often not indicative of future results.