To forecast stocks, it’s always the economy

Which way will the winds blow?

It’s the economy, stupid.”

– Bill Clinton’s campaign sound bite.

The old adage is that “the stock market has predicted 11 out of the last 7 recessions.” All that means is that the stock market is an important, but not infallible, predictor of the economy.

But what about the converse? How much does the economy predict future stock market performance? At first blush this seems backward. If the stock market’s level represents the sum of hopes and fears about the economy, and about corporate profits resulting from that economy, isn’t the stock market the leading indicator? Why study economic releases if they are nothing but backward-looking pieces of information?

My short answer is that to the extent that forecasts of the economy are proved to be too optimistic or too pessimistic, the stock market reacts to this new information. For example, the election of Donald Trump was a surprise, and with this surprise came a more optimistic view of the future of the economy. However, the economic statistics still had to continually corroborate this view, or else it would eventually become a discarded theory rather than a true driver.

President Trump’s first two years have indeed been one of economic strength, not just domestically but worldwide. GDP and final demand are robust; these two factors have the bullish stock market sentiment intact until the most recent month, when rising bond yields and increasing tariffs have caused a minor sell-off. However, stocks tend to do well from November to March, especially if October was a poor month. So historically, stocks are due to perform well once again.

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