US economic growth contracted 2.3% in 2020, the worst year for the economy since 2008.
Did that hurt the stock market?
Not at all. The S&P 500 gained 18%, well above its historical average return of 10%.
2020 wasn’t the first time we’ve seen a higher stock market in spite of an economic downturn. The same thing happened in 8 other years since 1930…
What about the opposite situation? Has the stock market ever declined when the economy has grown? Yes, we’ve seen that happen 18 times, most recently in 2018.
On a calendar-year basis since 1930, there’s a 0.25 correlation between the S&P 500’s total return and the change in real GDP. That translates to an r squared of .06 which in plain English means that only 6% of the variation in the S&P 500 from year-to-year can be explained by changes in economic growth.
That’s not to say that stocks and the economy haven’t both moved higher over long periods of time. That’s certainly been the case…
But in any given year it’s impossible to predict how one variable (the economy) is going to impact the other (stocks).
Why are stocks not moving precisely in tandem with the economy?
For one thing, stocks tend to be a leading indicator of the economy. That means in years like 2020 when growth was negative, stocks were looking ahead to better growth to come (we’re on pace for 6% real GDP growth in 2021).
It also means that in years like 2000, when growth was positive, stocks were looking ahead to weaker growth (recession began in March 2001).
Where this gets complicated is that stock returns are frequently not telling you anything important about the economy, but instead simply reflecting changing investor sentiment. At times investors will pay more for a given level of earnings and at other times they will pay less. What’s going on in the economy is just one factor in that determination.
Stocks are ultimately a reflection of what investors are willing to pay today for a stream of long-term corporate earnings, which is not nearly the same thing as changes in short-term economic growth.
Hence, the stock market is not the economy. Understanding that as an investor is critical.
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Disclaimer: All information provided is for educational purposes only and does not constitute investment, legal or tax advice, or an offer to buy or sell any security. For our full disclosures, click here.
