Each day, investors are treated to news about the economy and information about how the stock market has done recently. It can be very difficult to process what's going on because at any given moment in time, there may be very little correlation between how things are going in the real world and how prices are acting on Wall Street.
The noted fund manager and author Ralph Wagner once described the relationship between the economy and the stock market thusly:
"There's an excitable dog on a very long leash in New York City, darting randomly in every direction. The dog's owner is walking from Columbus Circle, through Central Park, to the Metropolitan Museum. At any one moment, there is no predicting which way the pooch will lurch."
"But in the long run, you know he's heading northeast at an average speed of three miles per hour. What is astonishing is that almost all of the dog watchers, big and small, seem to have their eye on the dog, and not the owner."
I use this analogy all the time to help people understand how the economy and stock market play off of each other. One of the hardest things to do as an investor is to entertain two opposing thoughts in our minds at once, and find a way to keep them despite the cognitive dissonance this can produce.
One of the most ironic aspects of investing is that the greatest gains lie ahead at times when things are bad, but not quite as bad as everyone suspects, and slowly, almost imperceptibly getting better. This is the moment when assets are selling at discounted values and the opportunities are laying at our feet, there for the taking.
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Conversely, the worst time to invest is once everyone agrees that the environment is terrific and that the gains will continue as far as the eye can see. It is at this moment we find ourselves paying up for assets and competing with lots of other buyers.
But most of the time, neither the economy nor the stock market is as good as it could get, or as bad as it could get. Typically, the economy trudges along a straight path for years at a time and it's the stock market that is easily excitable, ripping to and fro based on the latest information to hit the tape. Over longer periods of time, we do see a correlation between stocks and the economy, but over periods of less than a year, there is literally no rhyme or reason for what has happened. All explanations are simply ex post facto; an expert grasping at straws to assemble a reasonable take on what has occurred, and why it ought to have been obvious to everyone.
Investors are not well served by incorporating economic expectations into their long-term investment plans for the following reasons:
- The future is impossible to predict.
- Even if you knew what would happen in the future, you would still have to guess about what that might cause buyers and sellers to do, and how sentiment might shift in the investment markets.
- There were many years during which stocks have rallied as the economy had performed worse than expectations. There are also years during which economic data was strong but stock prices were weak. And then we've seen literally everything in between. No one can reliably predict which of these scenarios is more likely to occur in advance.
Understanding the economy is a helpful exercise. Placing market bets as a result of this understanding is a carnival game on the midway.
Disclosure: NBCUniversal and Comcast Ventures are investors in Acorns.
