Why the ‘Economy’ does not equal the ‘Market’
Highlights (in case you care, but not enough to read the full thing!):
Economic activity fluctuations are referred to as business cycles. Phases of the cycle are expansion, peak, contraction, trough, and recovery.
Economic indicators give hints about where we are in that cycle. These indicators are either Leading, Lagging, or Coincident.
The stock market is a leading indicator of the economy, meaning actions of the market are anticipatory of what is expected to happen in the economy in the near-ish future. And this is why the economy does not equal the market.
We hear “The economy is booming” and think YAY! Or “The economy is depressed” BOO! Or “The economy is recovering” NO IDEA!
Like so many things, the term economy is widely used but rarely defined.
It’s referred to as a single entity, when in fact the ‘economy’ is millions of buying, selling, lending, and borrowing decisions made by individuals, companies, and governments.
And while headlines would make you think it’s unusual, the ‘economy’ does not equal the ‘market’. Why?
Macroeconomics!
Don’t yawn too loudly, but we’ll start with macroeconomics (Hi Dad!) – it’s the study of the economy as a whole.
Macroeconomics is about the impact of inflation, unemployment, interest rates, exchange rates and more on the economy.
And it’s those very macroeconomic conditions (inflation, interest rates, etc.) that affect our actions and behaviours – people, businesses, and governments respond to these big macroeconomic conditions.
Gross Domestic Product (GD)
We hear “GDP” a lot, but don’t necessarily think about what it means. Gross domestic product (GDP) is the total value of everything produced in a country over a period of time.
GDP per capita is equal to GDP divided by the population – this gives us a sense of a country’s total output per person, which allows comparison between countries.
Economic Growth
Economic growth is usually the percentage change in GDP and depends on things like the efficiency of workers and the availability of technology. With technological progress, we’ll be more efficient, and productivity and output will increase, so the theory goes.
There are many of this: typesetting allowing the mass production of printed materials and textiles, automation of automobile production, DIY online tasks like travel planning and investment management.
But as technology boosts economic productivity, it’s disruptive in the sense that while new jobs are created, others become irrelevant. Productivity gains can mean lower demand for labour (this is economist-speak for: fewer jobs available).
The Business Cycle
Economy-wide fluctuations are called business cycles, but don’t be lulled into thinking they’re smooth and predictable – they’re not. But they can be roughly broken into the following phases:
1. Economic Expansion
During an economic expansion, production increases and inflation and interest rates both go up.
A low rate of unemployment means that employees can demand higher wages, putting upward pressure on costs and prices. Interest rates climb as more people and companies demand access to borrowed money to finance their spending and investing.
When an economy is growing faster than its resources might allow, the increased demand for products, services and labour can create inflation.
2. Peak
At a peak, economic growth reaches a maximum level.
Central banks may, around this time, purposefully do things to try to slow the economy and control inflation – the big thing they do is raise interest rates to try to get us to stop borrowing so much money.
Businesses fret about having to raise prices or slow their production, possibly due to the high cost of labour. Shocks, such as natural disasters, pandemics, or geopolitical events can also suddenly create a peak.
3. Contraction
During a contraction, the rate of growth slows – the economy might still be growing, but just not as fast as before the peak.
If economic activity declines enough, a recession may occur. A recession is most commonly defined as a significant decline in economic activity spread across the economy, lasting more than a few months, as measured by GDP, employment, industrial production, and retail sales.
In a contraction, central banks tend to lower interest rates to encourage businesses and people to borrow money to encourage spending, but often unemployment still increases because businesses can’t afford to keep the same number of people.
4. Trough and recovery
A trough marks the bottom of the contraction phase and the beginning of the recovery phase.
In a trough, the economy stabilizes and there is no further contraction. Eventually, companies need to replace obsolete equipment and individuals need to purchase new household items, spurring more spending.
Lower interest rates may have encouraged more borrowing to finance spending because confidence has returned. Finally, the economic growth rate begins to improve, and the economy enters a recovery phase.
Economic Indicators
Economic growth is not easy to measure.
GDP is common economic indicator, but it’s estimated with a large time lag and not that frequently.
So other indicators are used to gain insight into where we are in the business cycle such as:
Industrial output from manufacturing
Claims for unemployment insurance
Retail sales
Construction spending for commercial and residential properties,
Sentiment surveys indicating our confidence in the future
Economic indicators are often categorized as:
1. Lagging
These indicators tell us about a change in economic activity after it has already happened. An example of a lagging indicator is the employment rate, which tends to fall after economic activity has already declined.
2. Coincident
These indicators tell us about current economic conditions, but do not have predictive value. Examples of coincident indicators include industrial production and personal income statistics.
3. Leading
These indicators typically signal change and are therefore useful for economic prediction. Examples of leading indicators include broad stock market indices, such as the S&P 500 Index.
Summary
In this article, you learned the lingo of the business cycle, which describes the stages of economic activity fluctuations. You can now visualize the phases of the cycle over time as expansion, peak, contraction, trough, and recovery.
You also now see that economic indicators highlighted in the media give hints about where we are in that cycle.
Importantly, you can now categorize these indicators in your mind as either Leading, Lagging, or Coincident.
And finally, and probably most relevant to your peace of mind, you know that the stock market is a leading indicator of the economy, meaning actions of the market are anticipatory of what is expected to happen in the economy in the future.
And this is why your stock investments are doing great even though the economy is not.
