Markets & the Economy Are Disconnected

The greatest fallacy for traders and all of us is that the equity markets reflect the health of the economy. It doesn’t, full stop!

One of the many fallacies confusing the masses seem to be the expectation that one can invest in the stock market based upon their expectations for the economy. Many believe that if they follow unemployment, or GDP, or many other factors they will be able to glean what the stock market will do.

So, then why are those that invest in the market based upon the economy so confused?

All their confusion is based upon the fallacy of the assumption that understanding the economy will allow you to understand the market. To be honest, the exact opposite is true.

I have tried to explain why many view the causality chain backwards, but it bears repeating.

Fundamentals follow the market, and do not lead it. This is why we often hear that the stock market is a leading indicator for the economy.

So, taking this one step further, we understand that when a market reaches a maximum point of relative bullishness, it will top and turn in the opposite direction. The same applies when the market reaches a maximum point of bearishness, where it will bottom and turn in the opposite direction.

Alan Greenspan stated it in 2008: “The cause of economic despair, however, is human nature’s propensity to sway from fear to euphoria and back, a condition that no economic paradigm has proved capable of suppressing without severe hardship. Regulation, the alleged effective solution to today’s crisis, has never been able to eliminate history’s crises.”

With this in mind, let’s review how the stock market and economy relate to each other: uring a negative sentiment trend, the market declines, and the news seems to get worse. Once the negative sentiment has run its course after reaching an extreme level, and it's time for sentiment to change direction, the public becomes subconsciously more positive. Once you hit a wall, it becomes clear it is time to look in another direction.

When people begin to turn positive about their future, they are willing to take risks. What is the most immediate way that the public can act on this return to positive sentiment? The easiest is to buy stocks. For this reason, we see the stock market lead in the opposite direction before the economy and fundamentals have turned. HIstorically, we know that the stock market is a leading indicator for the economy, as the market has always turned well before the economy does. This is why R.N. Elliott, believed that the stock market is the best barometer of public sentiment.

When the public's sentiment turns positive, this is the point at which they are willing to take more risks based on their positive feelings. Whereas investors immediately place money to work in the stock market, thereby having an immediate effect upon stock prices, business owners and entrepreneurs seek loans to build or expand a business, which takes time to secure.

They then place the newly acquired funds to work in their business by hiring more people or buying additional equipment, and this takes more time. With this new capacity, they are then able to provide more goods and services to the public, and, ultimately, profits and earnings begin to grow.

When the news of such improved earnings hits the market, most market participants have already seen the stock of the company move up because investors effectuated their positive sentiment by buying stock well before evidence of positive fundamentals. This is why so many believe that stock prices present a discounted valuation of future earnings.

Clearly, there is a significant lag between a positive turn in public sentiment and the resulting positive change in the underlying fundamentals of a stock or the economy.

This is why I claim that fundamentals are a lagging indicator relative to market sentiment. This lag is a much more plausible reason as to why the stock market is a leading indicator, as opposed to some form of investor omniscience. This also provides a plausible reason as to why earnings lag stock prices, as earnings are the last segment in the chain of positive mood effects on a business growth cycle. It is also why those analysts who attempt to predict stock prices based on earnings fail so miserably.

So, for those of you that have been confused of late as to why the economy and the market are seemingly disconnected, I hope you begin to consider the significance that market sentiment plays within our market.

And, to drive home this point, allow me to provide you with one more quote. Bernard Baruch, an exceptionally successful American financier and stock market speculator who lived from 1870-1965, identified the following: “All economic movements, by their very nature, are motivated by crowd psychology. Without due recognition of crowd-thinking ... our theories of economics leave much to be desired. ... It has always seemed to me that the periodic madness which afflicts mankind must reflect some deeply rooted trait in human nature - a trait akin to the force that motivates the migration of birds or the rush of lemmings to the sea ... It is a force wholly impalpable ... yet, knowledge of it is necessary to right judgments on passing events.”

Now, I know there are many readers out there that are convinced that the only reason the market has reached the current heights is due to the Federal Reserve stimulus.

For those that have tracked our work for years, you would likely know that we have been extremely accurate in our analysis. While we certainly have not been perfect, we have provided our subscribers with forecasts which have protected them from major market downturns (like February and March of 2020), along with identifying where major market upturns will likely take hold (like at the end of March 2020).

While these are just two examples of how we have successfully used market sentiment to identify major turns in markets, we have been equally successful in identifying the major top in gold in 2011 and the major bottom in 2015, the major bottom in the U.S. dollar in 2011 along with the major top in 2017, the major bottom in bonds in November 2018 and many other larger degree turning points across all major markets.

In the meantime, I am expecting much more bad news to hit the wires in the coming months. And, if you continue to allow those headlines to sway you into following the negativity about the economy, then you will likely miss out on the next major buying opportunity I expect to see as we head towards the fall of 2020.

In fact, I am still of the belief that this buying opportunity will likely be your last before we begin our next multi-year stock market rally before we strike the top to the bull market which began in 2009.

All of this is not to persuade you to subscribe, but to look at price and ignore the talking heads that simply try to apply the latest headline to the market’s movement. There is much more to it.

Avi Gilburt is a widely followed Elliott Wave analyst and founder of ElliottWaveTrader.net, a live trading room featuring his analysis on the S&P 500, precious metals, oil & USD, plus a team of analysts covering a range of other markets.