The Equity Markets and the Economy
A question I am often asked is how equity markets are connected to the overall economy. The premise is a simple one: if the equity markets are hitting all-time highs, does that necessarily mean the economy is doing well?
One might be tempted to assume that because the Dow recently closed above 26,000 that this necessarily means that economic growth is currently strong. While the US economy is better than it has been in recent times, it is still not robust in terms of GDP growth. The recent tax cut that has been enacted with the promise that GDP growth will ramp up based on lower tax rates for corporations; we shall see. But it’s important to recognize that just because markets rally now, that doesn’t necessarily mean the economy is strong. Additionally, there is no guarantee that it will be strong going forward.
Our opinion is that the US unemployment rate has reached a multi-decade low and that certainly is a positive. However, we also believe that wage growth (the amount that workers’ paychecks are increasing) has lagged historic levels and is one of the reasons why the Federal Reserve has hesitated to raise interest rates. Wage growth is an important consideration in measuring the overall health of an economy and, as it stands now, wage growth is not currently impressive. Remember that equity markets tend to be an anticipatory indicator of expectations for future economic growth. With markets rallying strongly, there is significant hope being expressed by equity investors that economic growth, including wage growth, will ramp up. There is reasonable argument to be made that this hope may be excessive.
What does history tell us? When one examines the last major tax cut (during Ronald Reagan’s presidency), it was a mixed outcome in terms of the economic growth that occurred from lower taxation. It is a bit concerning the equity markets are so convinced that GDP expansion is a given. If GDP growth does not ramp up as expected, there could very well be an unpleasant reaction by investors in equities.
The disconnect between equity prices and economic growth begs one obvious question; are the equity markets too euphoric and have they rallied too fast? Said another way, are valuations justifiable given current economic conditions and future expectations? Our view is that a wave of euphoria has taken over from pragmatic judgments about the economy. There’s a reason why we invest with a recognition that markets do not always go up. Believe it or not, sometimes markets go down and we believe some investors have lost sight of this reality. We remember too well the various corrections, bear markets, and economic challenges that caused havoc in equity markets. This is why whenever we buy assets, we carefully assess the wisdom of positions that we invest in on your behalf and consider the volatility characteristics of each position.
Perhaps I sound overly pessimistic given the optimism you might be hearing in the media. That’s actually not the case. I am actually somewhat optimistic about the future of the economy (as long as you don’t look short-term at the level of the national debt). But I do feel it is important to be grounded in rational thought and not be carried away by market sentiment and emotion. For that reason, chasing high beta, high volatility assets we believe can expose portfolios to significant volatility particularly given market levels. Fundamental analysis guides how we invest combined with a framework of prudent allocation. We are uncomfortable chasing pure momentum assets as we simply do not want to expose portfolios to the type of risk these assets can bring to portfolios.
I know it may seem that markets will rally forever. The truth is markets go up and go down. Euphoria can be dangerous and we believe strongly that a healthy dose of paranoia is necessary when developing an investment strategy, particularly given the current economic environment. We will continue to adjust and rebalance as necessary and take the actions we feel are prudent. We believe it is our responsibility to do all we can to try to grow your assets while at the same time recognizing that volatility is also a concern.
So what is my answer to the question about equity markets and the connection to the economy? Strong equity markets do not necessarily imply a strong economy. Consequently, one must carefully watch and assess any disconnect that might be occurring and factor that into portfolio strategy construction.
If you have any questions about this information, do not hesitate to let me know. I’m happy to answer any questions you might have. Hope your new year is off to a great start and wishing you all the best in 2018.