The Stock Market as a Leading Indicator

If you look at economic growth and stock market prices in a country, they often don’t correlate. The economy booms but the stock market doesn’t. Or the stock market booms and the economy doesn’t. One of the most important reasons for this phenomenon is that stock markets can sometimes be leading indicators.

In other words, the stock market anticipates a coming economic change and may decline if an economic downturn is coming and may increase if the economy is expected to improve. The stock market and economy don’t always move in tandem, so often you see economic growth advancing after the stock market has made a move to the upside, and vice versa on the downside.

For example, growth in Turkey came in at a modest 2.2% in 2012, yet its stock market was one of the world’s best performers that year, rising more than 50%.[1]

But if growth is fast in a country, the companies doing business in it could also grow fast. Of course, there are many intervening factors, such as a war or epidemic, which could upset this correlation. Nevertheless, if you take a long-term view, most often the correlation should hold out.

Rhetoric surrounding the US Federal Reserve’s “QE” program (and its eventual end) has created a lot of global market noise of late. The impact of monetary policy actions doesn’t always show up in an economy immediately; we believe it should result in more inflows of assets globally into stocks as the money makes its way into the system - even after the Fed’s buying program ends. While the uncertainty of the timing has created some near-term panic, some investors may be losing sight of the fact that the Fed is focused on employment, and doesn’t appear likely to withdraw until there is more improvement on that score, although the unemployment numbers have been coming down over the past year. The amount of money that the Fed has pumped into the US and, indirectly, the global system, should be a good thing for markets all over the world, including emerging markets, of particular interest to me.

It’s also important to note that the US isn’t the only global market driver anymore, as policy and politics in other emerging markets like India, China, and Brazil can have dramatic influence on the global stage (as we’ve seen recently). That said, it’s important to note that a decline in unemployment in the US would be an indicator that the US economy appears to be on a faster growth path. Although there are no guarantees, the steady rise of the US equity market for the last few years could possibly be the leading indicator for the economy that we have been talking about.

From time to time investor expectations become irrational and people forget about fundamentals, which could be what we have seen recently given market volatility not only in the US, but in other markets around the world. Money can be moved in and out of a market at a moment’s notice, creating asset bubbles as well as short-term market panics. In the end, we believe the earnings capacity of companies should prove the ultimate driver of long-term stock market performance, and eventually investors come to their senses. It often takes a lot of discipline to stay away from the emotion of short-term market swings and invest following long-term fundamentals.

We have to recognize that volatility in the markets is likely here to stay, which makes it even more important to take a longer-term view. All markets are subject to the psychology of the masses, and tend to overshoot and undershoot. With high frequency trading, derivatives, leverage and programmed trading coming on the scene in recent decades, the highs and lows of market prices have tended to become wider and volatility has generally been rising. So if you can ignore the volatility and factor emotion out of the equation to base your investment approach on long-term fundamentals, I believe you can do far better than trying to time the market. Overshooting in both directions tends to even out over time, and generally stock markets do eventually reflect long-term economic growth trends.

In my view, the best way to take advantage of volatility is to honor the time-honored value-investing strategy first pioneered by our mentor, the late Sir John Templeton, often called the godfather of global investing. His basic philosophy, which we still emulate today at Templeton, is threefold:

- Search the world for investment bargains

- Focus on the long-term, not the short-term

- Use common sense

The third point is often the hardest. Buying when others are selling and selling when others are buying often requires great mental discipline. Whether it’s the dotcom bust, the subprime crisis or another bearish market catalyst, we believe that’s when the best values can be uncovered. It’s important to focus on stocks with good long-term recovery prospects to weather short-term challenges. That’s where astute, bottom-up research comes in—and where we think the best opportunities can be found.

For more on the pitfalls of following the crowd, here’s a fun video on the topic.

US investors can view the video here

Non-US investors can view the video here

Photo: Andrew Burton/Getty Images