There’s a common belief among financial advisors and sophisticated investors: “The stock market is a leading indicator of where the economy will be in the not too distant future.” In fact, economic and finance courses at universities often teach this. However, there’s a challenge with this understanding because the stock market doesn’t seem connected to any underlying economic frame of reference, especially in the near term. Instead, near-term market gyrations are the product of rapidly changing investor sentiment, which impacts demand to buy or desire to sell shares with its finite stock market supply.
In this article, I’ve prepared research looking back at the past two decades of market and economic data to help financial advisors and savvy investors better understand the market-economy dislocation. Furthermore, the reason this is so important is that even though on every investment brochure or prospectus you’ll find a statement along the lines of “Past performance is not indicative of future results,” most typical investors don’t care, in my experience. They proceed doing precisely the thing that, in bold letters, they are told not to do — using past performance to gauge where to allocate their funds.
Using data publicly available from the Bureau of Economic Analysis at the U.S. Department of Commerce and subscription available data from Macroeconomic Advisers/IHS Markit, I compared data framed within the two most recent decades (January 1, 2001, to December 31, 2010, and January 1, 2011, to December 31, 2020). These are both interesting decades as they each contain at least one major economic recession and at least one major stock bear market.
To illustrate how perilous using past performance could be, I imagined a “typical investor,” described earlier as someone who uses past performance to make current investment decisions. This investor happens to be waking up with a slight hangover on January 1, 2011, excited to invest in stocks using the cash pile they’ve accumulated in money market funds over the past decade.
This research found that from January 1, 2001, to December 31, 2010, the stock market (as measured by the price level return of the S&P index) saw a cumulative –4.74% return (calculation with no dividends reinvested). Although the years included sometimes differ, in professional circles, you commonly hear this decade aptly referred to as “the lost decade” because you’d have done better investing in most any money market fund. Our investor looked at their morning newspaper to select their investment for the decade ahead, using its past decade performance as their decision-making guide. When reading an S&P Index fund’s total return (with dividends reinvested) of 1.41% annualized over the past 10 years, our investor knew immediately that investment was sure to be a loser and decided to stay put in their money market fund. “After all,” they thought, “I have gotten as much total return from my money market fund over the past decade and without all the indigestion from stock market crashes.”
Even though the lost decade soured many investors on U.S. stocks, that same period, my analysis found, witnessed an incredible 144.5% (9.59% annualized) growth rate on U.S. corporate profits. Also, U.S. GDP grew 46.84% (3.91% annualized) during this depressing stock market time frame. Underlying economic dynamics were laying a foundation for future growth but were summarily ignored by many stock market investors. Instead, the crisis du jour captured their attention, and the capital moved accordingly.
In the following decade, between January 1, 2011, and December 31, 2020, my analysis found that the stock market had an annualized total return of 13.87%, or 267% cumulatively. Meanwhile, U.S. corporate profits grew at a comparatively meager annualized rate of 2.49%, and U.S. GDP grew at a lower than previous decade 3.43% annualized rate. To add insult to injury for our investor, money market rates ended the ’10s decade with an average 0.07% annual yield. Understandably, they got misty-eyed and nostalgic for those money market fund yields above 5% nearly 20 years earlier.
Stock market volatility is a normal dynamic. News media and the 24-hour news cycle have fueled frenzied reactions to investors’ euphoric or fearful reactions. Layer in the spreading of ideas through online investing forums, and you have yourself a mighty powerful concoction of supply and demand market dynamics on full display, every day. All this noise distracts and is completely disconnected from underlying economic fundamentals.
The savviest investors understand that investing today takes much more patience and resolve to stay the course as new market participants and their sentiment have rocked global capital markets. As the data presented here suggests, the stock market eventually catches up to underlying economic conditions, so much so that economic conditions today could be indicative of stock market returns for the next several years. But such a conclusion would contradict that today’s stock market prices are any kind of leading indicator; instead, they are a litmus of current feelings about the state of things.
This article originally appeared on Forbes.
